Interest on reserves, unregulated interest on demand deposits, and optimal sweeping

This paper examines the joint determination of the interest rate on demand deposits and swept funds given interest on reserves and the elimination of Regulation Q. Our model works within monopolistically competitive loan and deposit markets and incorporates sweeping from deposit accounts to reserve-exempt accounts. Under unregulated deposit rates, we derive solutions for the market equilibrium values of the deposit rate and the share of deposits allocated to swept funds. Sweeping responds positively to the interbank loan rate and marginal resource costs for unswept funds, and negatively to the interest rate on reserves, reserve ratio, and the marginal resource cost of sweeping. The deposit rate responds positively to the interbank loan rate, interest rate on reserves, and reserve ratio, but negatively to marginal resource costs of sweeping and holding unswept funds. We also investigate deposit market equilibrium under a zero deposit rate restriction with sweeping. Here, the share of swept funds and the portion of the interbank rate passed on to swept balances adjust to attain market equilibrium. Sweeping enables banks to replicate outcomes from unhindered deposit rate competition. The equilibrium return that banks pay depositors and the share of swept funds are the same as with unrestricted deposit rates.