Question

The bank of Zambia is discussing the possibility of paying interest on excess reserves . If it occurs , what will happen to the level of excess reserves to deposits ratio?

Answer 1

Interest on Excess Reserves (IOER), is the interest paid on those balances that are above the level of reserves the Depository Institutions is required to hold. Paying IOER reduces the incentive for DIs to lend at rates much below IOER, providing the Federal Reserve additional control over the federal funds effective rate (FFER).

When banks earn interest on their reserves, they have no incentive to lend at interest rates lower than the rate paid by the central bank. The central bank can therefore adjust the interest rate it pays on reserves to steer the market interest rate toward its target level.

Textbook accounts of the money multiplier assume that banks do not earn interest on their reserves. A bank holding excess reserves in such an environment will seek to lend out those reserves at any positive interest rate, and this additional lending will lower the short-term interest rate. This lending also creates additional deposits in the banking system and thus leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself, with banks making more new loans and the short-term interest rate falling further. The multiplier process could continue until excess reserves are eliminated—that is, until the increase in lending and deposits has raised required reserves all the way up to the level of total reserves.

If this happens, the money multiplier will be fully operational. However, the process will stop earlier if the short-term interest rate reaches zero. When the market interest rate is zero, the opportunity cost associated with holding reserves disappears. At this point, banks no longer have an incentive to lend out their excess reserves, and the multiplier process halts. As noted earlier, however, most central banks now pay interest on reserves. When reserves earn interest, the multiplier process will not continue to the point where the market interest rate is zero. Rather, it will stop when the market rate reaches the rate paid by the central bank, since if these rates are the same, banks no longer face an opportunity cost of holding reserves. If the central bank pays interest on reserves at its target interest rate, as we assumed in our example above, then banks never face an opportunity cost of holding reserves and the money multiplier does not come into play. It is important to keep in mind that the excess