Question

The Federal Reserve pays interest on the reserve deposits banks hold with the Fed. Explain if and how the banks could earn any profit without cost in the following situations by taking advantage of differences in the Discount rate, Federal funds rate and interest paid on reserves. Banks would just borrow/lend each other or from the Fed or hold reserves in their account.

A. The discount rate is 2%, the effective federal funds rate is 2.5% and the interest paid on reserve deposits is 1.5%.

Answer 1

When Federal Reserve will buy $50,000 of US government bonds, banks will experience an increase of $50,000 in reserves as Fed will make payment of $50,000.

Required reserve ratio = 0.20

Money multiplier = 1/RR = 1/0.20 = 5

Increase in money supply = Increase in reserves * Money multiplier

Increase in money supply = $50,000 * 5

Increase in money supply = $250,000

Thus, if the assumptions of the money multiplier hold, this will increase the money supply by $250,000.

Money multiplier can only hold or can be applicable, if banks do not hold any excess reserves. In this situation only that full impact of money multiplier can be observed.

In case banks hold excess reserves and do not lend them in entire quantity then in that case banks will make fewer loans which in turn will lead to diminished increase in money supply.

The opportunity cost of holding reserves is the interest foregone that can be earned by lending them.

Interest on reserves acts as substitute of interest on loan that can be earned by the bank by lending the reserves instead of holding them.

So, increasing the IOR decreases the opportunity cost of holding reserves and thus decreases the effect of the money multiplier on the economy.