Question

) In the past, the Federal Reserve didn’t pay interest on reserves kept in Federal Reserve banks. For an ordinary U.S. bank, money kept at the Fed earned zero interest, just like money stored in a vault or in an ATM. In 2008, the Fed started paying interest on deposits kept at the Fed. Briefly explain all your answers.

Once the Fed started paying interest, what would you predict would happen to the demand for reserves by banks: Would they demand more reserves of fewer reserves from the Fed?

If a central bank starts paying interest on reserves, will private banks tend to make more loans or fewer loans, holding all else equal? (Hint: Does the opportunity cost of making a car loan rise or fall when the central bank starts paying interest on reserves?)

Let’s put parts a and b together, keeping in mind the fact that bank loans create money. That means your answer to part b also tells you about the money supply, not just about the loan supply. If a central bank starts paying interest of reserves, will the reserve ratio chosen by the banks tend to rise or fall (will banks hold more or less reserves in excess of the Fed’s requirements)? And will the money multiplier tend to rise or fall?

Your answer to part c tells us that when the central bank starts paying interest on reserves, there’s going to be a shift in the money supply. But there are a lot of ways to affect the money supply, so if a force is pushing the money supply in one direction, we can find another tool to push the money supply in the opposite direction. Therefore, if a central bank chooses to start paying interest on reserves, but it wants the money supply to remain unchanged, what should the central bank do to the supply of reserves: Should it increase the supply of reserves or decrease the supply of reserves?

Answer 1

. a. Banks would demand more reserves once the Fed starts paying interest. Without interest, reserves are a hassle to hold. With interest, reserves are no problem to hold.

b. All else being equal, banks will probably make fewer loans once the Fed starts paying interest on reserves. If you can earn decent interest by just lending money to the Fed, why bother searching for good customers to loan to?

c. This will push up reserve demand, which will push up the reserve ratio and push down the money multiplier.

d. The central bank will need to raise the supply of reserves through open market purchases to undo the money-destroying effect of the decision to pay interest on reserves.