Question

Since 2008, the Federal Reserve pays interest on reserve balances held by depository institutions. Specifically, interest is paid on required reserves to ________ , and interest is paid on excess reserves to____________.

a) reduce the incentive for depository institutions to lend at rates much below this interest rate; effectively eliminate the implicit tax (opportunity cost) that reserve requirements used to impose.

or

effectively eliminate the implicit tax (opportunity cost) that reserve requirements used to impose, reduce the incentive for depository institutions to lend at rates much below this interest rate.

Answer 1

The correct answer is : (b) effectively eliminate the implicit tax (opportunity cost) that reserve requirements used to impose, reduce the incentive for depository institutions to lend at rates much below this interest rate.

Since the required reserves are mandatory to be maintained by commercial banks they represent an opportunity cost. They could have been lent to general public and banks could have earned interest on them but rather they are locked in. Thus Fed pays interest on required reserves to eliminate this opportunity cost.

The excess reserves are discretionary. The Fed pays interest on excess reserves to incetivise banks to not lend freely (at lower interest rates). If banks use excess reserves to generate loans, the quantity of excess reserves decreases and the interest they earn by Fed is earned on smaller quantity of reserves.