Reply To: Higher interest rates and excess reserves


As we have seen in the last few days, even a hint from the Fed that its expansionary policy might be scaled back soon led to a stock market sell off. If the Fed stopped expanding the monetary base, the asset price bubbles it has been fueling would burst. Interest rates would rise on the assets the Fed has been buying, namely, MBS and Treasuries. It’s not clear if that would set in motion a general rise in interest rates. It depends on how investors weigh the effects of a smaller stimulus to credit expansion against a reduced threat of price inflation.

Banks are not lending because they don’t see normal prospects for being paid back and they want to stay liquid. Banks have no incentive to lend their excess reserves. They can convert them into required reserves by issuing fiduciary media and expanding credit and still be paid interest by the Fed. The Fed pays interest on reserves, whether required or excess.

Price inflation will pick up as bank lending returns to normal (causing the money stock to expand more rapidly) and as money demand declines to normal.