In the past, the Federal Reserve didn’t pay interest on reserves kept in Federal Reserve banks: For an ordinary U.S. bank, money kept at the Fed earned zero interest, just like money stored in a vault or in an ATM machine. In 2008, the Fed started paying interest on deposits kept at the Fed.
a. Once the Fed started paying interest, what would you predict would happen to demand for reserves by banks: Would they demand more reserves or fewer reserves from the Fed?
b. If a central bank starts paying interest on reserves, will private banks tend to make more loans or fewer loans, holding all else equal? (Does the opportunity cost of making a car loan rise or fall when the central bank starts paying interest on reserves?)
c. Let’s put parts a and b together, keeping in mind the fact that bank loans create money. That means your answer to part b also tells you about the money supply, not just about the loans supply. If a central bank starts paying interest on reserves, will the reserve ratio chosen by banks tend to rise or fall? And will the money multiplier tend to rise or fall?
d. Your answer to part c tells us that when the central bank starts paying interest on reserves, there’s going to be a shift in M1 and M2, the broad forms of money supply that include money created through loans. But there are a lot of ways to affect the money supply, so if one force is pushing the money supply in one direction, we can find another tool to push the money supply in the opposite direction. Therefore, if a central bank chooses to start paying interest on reserves, but it wants M2 to remain unchanged, what should the bank do to the supply of reserves: Should it increase the supply of reserves or decrease the supply of reserves?