Reply To: Interest on Reserves


(1) Here is a story that claims the BOJ has realized that pushing interest rates down across the yield curve has removed the incentive for banks to lend long-term. As a result, less spending on capital capacity takes place and aggregate demand slumps. The story has a Keynesian bias, but makes a valid point about the supply of credit.

(2) The Fed desires to control the broader money stock and credit supply in society, but it only directly controls the monetary base. The monetary base = currency + bank reserves. The banks have discretion in issuing fiduciary media (i.e., checking account balances) on top of their reserves. Bank checking accounts, as money substitutes, are part of the money supply. In normal times banks tend to stay fully loaned out, carrying almost no excess reserves. They do so because they earn interest on their loans and do not feel the need for liquidity beyond their required reserves. In such times, the Fed can control the money supply fairly well. But when the financial crisis hit, the Fed bailed out banks with QE1 and QE2, buying their MBS and paying with reserves. The banks desired liquidity and given the collapse of demand for credit and consequent low interest rates and heightened uncertainty of the investment climate, they built up their excess reserves to levels not seen since the Great Depression. In such times, banks can increase the money supply independently of Fed policy by issuing more fiduciary media via new loans to customers. Doing so will reduce their excess reserves, but they can continue to expand until they are fully loaned up again. The Fed instituted payment on reserves to manage that process. The Fed has one rate it pays on required reserves and another rate it pays on excess reserves. So, if banks are issuing too much fiduciary media and converting their excess reserves into required reserves too vigorously, then the Fed can raise the rate it pays on excess reserves to entice banks to slow down the conversion.

Here is the official Fed release on interest payments on reserves.