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Interest Payments On Excess Reserves

A bank, as you may know, doesn’t actually hold on to the money that people deposit in it. Banks lend the money out. But they’re not allowed to lend all the money out. They have to hold some in reserve, and the quantity of money they need to hold is set by regulators. A bank, however, always might want to hold even more money in reserve. But if you look at history, it’s clear that American banks have never had any interest in holding on to so-called “excess reserves” until in the fall of 2008, the Federal Reserve started paying a small amount of interest on such reserves:

The stated reason for this policy makes very little sense to be. Allegedly, Ben Bernanke started paying interest on excess reserves in order to signal that in the future he might pay even more interest on excess reserves in order to soak up excess liquidity in case we end up with an inflation problem. But why does he need to pay a small amount of interest now in order to be able to pay a large amount of interest later? The underlying point of the interest on excess reserves policy is that such interest payments are contractionary. And at the moment the Fed is supposed to be engaging in expansionary policy. Why not go back to the long-settled tradition of paying zero percent interest? Why not pay attention to Sweden’s success in setting this as a negative number? Alternatively, if the view is that a giant increase in bank reserves is desirable (it makes the system safer, whatever) why not raise the required reserve level?

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