Interest On Excess Reserves

Impact on inflation of excess reserve balances

Research by personnel at the Fed has resulted in claims that interest paid on reserves helps to guard against inflationary pressures. Under a traditional operating framework, in which central bank controls interest rates by changing the level of reserves and pays no interest on excess reserves, it would need to remove almost all of these excess reserves to raise market interest rates. Now when central bank pays interest on excess reserves the link between the level of reserves and willingness of commercial banks to lend is broken. It allows the central bank to raise market interest rates by simply raising the interest rate it pays on reserves without changing the quantity of reserves thus reducing lending growth and curbing economic activity.