No Interest on Reserves and the Money Multiplier Throughout most of the Fed’s history interest was not paid on reserves. The ability to pay interest on reserves only came about in October 2008. Let’s talk about the situation before this point. A bank would thus be incentivized to lend at any positive interest rate. A bank has two choices Lend the excess reserves to another bank at Fed Funds or Lend the funds out in some other way. Let’s starty with a couple of definitions. The monetary base is equal to Currency in circulation Reserves Treasury monetary liabilities (<10%) The money supply can be defined either as M1 – The total amount of cash outside the banking industry plus all demand deposits (checkable deposits) M2 = M1 + most savings accounts, money market accounts and small size time deposits. The traditional view on excess reserves goes as follows. One would expect that an increase in bank reserves should be multiplied into a much larger increase in the money supply as banks expand their deposits and lending activities. The expansion in deposits should then raise reserve requirements to the point where there are little or no excess reserves in the system. This should work in the no interest on reserves situation because a bank holding excess reserves would seek to lend out these reserves at any positive interest rate (you earn more by doing this). This additional lending will decrease the short term interest rate. The lending will also create additional deposits. Because the increase in required reserves is small, however, the process will repeat itself until one of two things happen – either the increase in lending and deposits have removed the excess reserves from the system and one finds a new equilibrium interest rate or interest rates fall to zero and there is no further incentive for lending. Let’s go back to our Fed selling a security example and see what happens in practice. As they are earning nothing on the reserves they will try to get rid of the excess reserves. They can do this by lending the money out to an individual. If they lent the excess reserves through the Fed Funds market then they are simply transferring the problem to someone else who will lend to an indivudal/business. Thus someone receives a loan from Bank A. NonBank Public B Assets Liabilities Checkable deposit 90 Loan 90
No Interest on Reserves and the Money Multiplier Throughout most of the Fed’s history interest was not paid on reserves. The ability to pay interest on reserves only came about in October 2008. Let’s talk about the situation before this point. A bank would thus be incentivized to lend at any positive interest rate. A bank has two choices Lend the excess reserves to another bank at Fed Funds or Lend the funds out in some other way. Let’s starty with a couple of definitions. The monetary base is equal to Currency in circulation Reserves Treasury monetary liabilities (<10%) The money supply can be defined either as M1 – The total amount of cash outside the banking industry plus all demand deposits (checkable deposits) M2 = M1 + most savings accounts, money market accounts and small size time deposits. The traditional view on excess reserves goes as follows. One would expect that an increase in bank reserves should be multiplied into a much larger increase in the money supply as banks expand their deposits and lending activities. The expansion in deposits should then raise reserve requirements to the point where there are little or no excess reserves in the system. This should work in the no interest on reserves situation because a bank holding excess reserves would seek to lend out these reserves at any positive interest rate (you earn more by doing this). This additional lending will decrease the short term interest rate. The lending will also create additional deposits. Because the increase in required reserves is small, however, the process will repeat itself until one of two things happen – either the increase in lending and deposits have removed the excess reserves from the system and one finds a new equilibrium interest rate or interest rates fall to zero and there is no further incentive for lending. Let’s go back to our Fed selling a security example and see what happens in practice. As they are earning nothing on the reserves they will try to get rid of the excess reserves. They can do this by lending the money out to an individual. If they lent the excess reserves through the Fed Funds market then they are simply transferring the problem to someone else who will lend to an indivudal/business. Thus someone receives a loan from Bank A. NonBank Public B Assets Liabilities Checkable deposit 90 Loan 90