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A theory of hank reserves is presented with emphasis on the behavior of borrowed reserves, the Federal Reserve's operating instrument. The theory explains the observed nonlinear relationship between borrowing and the spread between the federal flow rate and the discount rate. The theory shows that borrowed reserves are also a function of deposit variation. A shift in bankers' perceptions of deposit variation can cause borrowed reserves demand to shift so that the level of borrowing is not a reliable indicator of the degree of reserve pressure. Since borrowed reserves are used as the Federal Reserve's operating instrument, problems such as these pose substantial risks to the implementation of monetary policy., Introduction In 1982 the Federal Reserve made borrowed reserves its operating instrument, the indirect target through which it achieves its monetary policy target. It was believed that borrowed reserves would [...]