Interest rate

What Happens If A Central Bank Pays Interest On Reserves

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• published: 03 Oct 2016
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Professor L. Randall Wray answering a question about the Fed paying interest on reserves. "Reserves" refer to the kind of currency that banks use to settle payments between each other (if I write a check to you, my bank reduces my account, then the Fed reduces my bank's reserve account, then increases your bank's reserve account, and finally your bank increases your account). The banks are required to hold a certain amount of reserves, but on any given day they might end up with less or more than this amount. If they have less, then they can borrow the needed reserves from a bank that has more in an overnight loan, to satisfy the requirement. The market for these loans is called the "Federal Funds market." The interest rate that banks pay in the Fed Funds market is determined by the Fed. If the Fed would like to lower interest rates, it adds reserves to the system buy purchasing bonds with newly created reserves. The banks are unable to eliminate the extra reserves, all they can do is transfer reserves between themselves. So, the extra reserves will drive down the interest rates on loans, since many banks with extra reserves will compete with each other to lend to few banks with shortfalls. On the other hand, if the Fed wants to raise overnight interest rates, it can sell bonds to the banks in exchange for reserves which get removed from the system. After draining these reserves, the banks will have a harder time finding somebody willing to lend their excess, and so interest rates will rise. Normally, when the government deficit spends, this adds excess reserves to the banking system. Because the government deficit spends a lot, this puts downward pressure on the Fed Funds rate. In fact, if the Fed and the Treasury didn't sell bonds to offset this addition, there would be a preponderance of excess reserves, and interest rates would fall to zero permanently. Under normal circumstances, to hit an interest rate target higher than zero, the Fed/Treasury must sell bonds to drain these reserves from the banking system. But there is another way the Fed can raise the interest rate above zero, and that is to pay interest on the reserves directly. No bank would be willing to lend its excess reserves at a rate lower than it could get than by simply holding them and collecting interest that the Fed is paying automatically, so interest on reserves (IOR) sets a "price floor" so that interest rates can't fall below the rate paid on reserves. Watch the whole video here: https://www.youtube.com/watch?v=0zEbo8PIPSc Check out the other videos by the nice folks over at the Modern Money Network: https://www.youtube.com/user/ModMonPubPurpose Follow Deficit Owls on Facebook And Twitter: https://www.facebook.com/DeficitOwls/ https://twitter.com/DeficitOwls