In October 2008, the Federal Reserve began paying interest on the amount of excess reserves held

step 1 Here we're taking a look at the money supply process, specifically during the 2008 Great Recessi

In October 2008, the Federal Reserve began paying interest...

Key Concepts

Interest on Reserves

This is a policy tool used by central banks, wherein financial institutions are paid interest on the reserves they hold beyond the mandatory minimum. By earning a return on excess reserves, banks may be less incentivized to lend out their funds aggressively, potentially reducing the overall creation of new money in the economy.

Excess Reserves

These are the funds that banks hold over and above the required minimum reserve ratio. The decision to hold excess reserves instead of lending them can affect how much additional money is created through the lending process, thereby impacting the effectiveness of the multiplier process in expanding the money supply.

Money Multiplier

The money multiplier reflects the idea that an initial deposit in a bank can lead to a greater final increase in the overall money supply, through successive rounds of lending and depositing. However, when banks choose to hold more excess reserves—especially if they earn interest on them—the multiplier effect may be dampened, limiting the growth of the money supply.

Bank Lending Behavior

Banks decide on the allocation of their funds based on profitability and risk. When paid interest on excess reserves, banks might prefer the secure, albeit lower, return from these reserves over potentially riskier lending activities. This shift in behavior can lead to a contraction in lending, thereby affecting the overall dynamics of the money supply creation process.

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