INTEREST-RATE SMOOTHNESS AND THE NONSETTLING-DAY BEHAVIOR OF BANKS

The variance of federal funds rates on nonsettling days was relatively low during the nonborrowed reserve period. As an explanation, we deve lop a model where banks maximize expected profits over the reserve mai ntenance period subject to transaction costs on the settling day (for simplicity, fixed costs) and a probability distribution of stochastic reserve flows. The equilibrium solution reveals the relation between t he microeconomic parameters-settling-day transaction costs and the res erve flow variance-and the variance of nonsettling-day rates. Casual e vidence suggests that regulatory innovations may have altered the rese rve flow variance to produce the observed degree of interest rate smoo thness.