Question

Suppose the Fed decides to decrease interest paid on reserves, what impact would this have on the money supply? Why is this?

Answer 1

If the Fed decides to decrease the interest paid on Reserves, then the commercial banks would be discouraged to park their excess Reserves with the Federal Reserve. So the commercial banks would not keep their excess Reserves with the Federal Reserve. What they will do instead is that they will loan out that excess reserve to those the credit.

This loaning out of the excess reserves by the commercial banks would lead to to an increase in the supply of money in the economy as the credit is expanded by the commercial banks.

This increase in the credit creation by the commercial banks and money supply is due to the decrease in the the interest paid on reserves by the fed.

Hence, decrease in interest paid on reserves by fed leads to a Increase in the money supply for the above mentioned reasons.