If liquidity costs exist in inter-bank markets or security markets, bank reserves are beneficial in reducing costs. An increase in bank reserves can lower nominal interest rates (liquidity effects). We develop a model of the demand for reserves from the bank's optimization condition under the reserve requirement regulation. We also test whether liquidity effects existed in the Japanese inter-bank market using daily data over August 1994 through September 1999. We find that liquidity effects existed only during the period of severe banking crisis, i.e., October 1997 through February 1999. Except for this period, liquidity costs seem to have been negligible.
