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Interest on reserves

Interest on Reserves

Interest on reserves refers to the interest paid by a central bank to commercial banks on the funds they hold as reserves. These reserves are balances that banks keep either in their own vaults or, more commonly, at the central bank. This mechanism falls under the broader category of monetary policy, serving as a crucial tool for central banks to influence the overall money supply and interest rates within an economy. By adjusting the interest rate on reserves, the central bank can influence banks' incentives to lend or hold onto their funds.

History and Origin

Historically, banks were often required to hold a certain percentage of their deposits as reserve requirements without earning interest. This effectively acted as an implicit tax on banks, as these funds could not be used for profit-generating loans or investments12. The idea of paying interest on reserves was first advocated by economists like Milton Friedman, who argued it would improve economic efficiency and simplify monetary policy implementation10, 11.

In the United States, the Federal Reserve gained the authority to pay interest on reserve balances through the Financial Services Regulatory Relief Act of 2006, with an initial effective date of October 1, 2011. However, the onset of the 2008 financial crisis accelerated this timeline. The Emergency Economic Stabilization Act of 2008 advanced the effective date to October 1, 2008. On October 6, 2008, the Federal Reserve Board announced it would begin paying interest on both required reserve balances and excess reserves to provide greater scope for its lending programs and to help maintain the federal funds rate near its target9. This marked a significant shift in the Fed's approach to implementing monetary policy.

Key Takeaways

  • Interest on reserves is a payment made by a central bank to commercial banks on their reserve balances.
  • It serves as a key tool for central banks to influence short-term interest rates and the overall money supply.
  • The Federal Reserve began paying interest on reserves in October 2008.
  • This policy impacts banks' decisions to lend or hold reserves, affecting credit availability and economic activity.
  • Interest is typically paid on both required and excess reserve balances.

Formula and Calculation

The interest paid on reserves is calculated based on the interest rate on reserve balances (IORB) set by the central bank and the average daily balance of reserves held by the depository institution.

The formula can be expressed as:

Interest on Reserves=IORB Rate×Average Daily Reserve Balance\text{Interest on Reserves} = \text{IORB Rate} \times \text{Average Daily Reserve Balance}

Where:

  • IORB Rate is the interest rate on reserve balances set by the central bank.
  • Average Daily Reserve Balance is the average amount of funds a commercial bank holds at the central bank over a specified period, including both required and excess reserves.

Interpreting the Interest on Reserves

The interest rate on reserves provides a floor for short-term market rates, particularly the federal funds rate. Banks are generally unwilling to lend funds to other institutions at a rate lower than what they can earn by simply holding those funds as reserves at the central bank. Therefore, by adjusting the interest rate on reserves, the central bank can directly influence the cost of overnight borrowing between banks and, consequently, broader interest rates in the economy8. A higher interest on reserves rate incentivizes banks to hold more reserves, reducing the availability of funds for lending and pushing other short-term rates upward. Conversely, a lower rate encourages banks to lend more, increasing liquidity in the system and potentially lowering lending rates.

Hypothetical Example

Imagine the central bank sets the interest rate on reserves at 4.00%. Bank A has an average daily reserve balance of $100 million with the central bank.

To calculate the daily interest earned by Bank A:

Daily Interest=0.0400×$100,000,000365\text{Daily Interest} = 0.0400 \times \frac{\text{\$100,000,000}}{365} Daily Interest$10,958.90\text{Daily Interest} \approx \$10,958.90

Over a month (approximately 30 days), Bank A would earn:

Monthly Interest=$10,958.90×30=$328,767.12\text{Monthly Interest} = \$10,958.90 \times 30 = \$328,767.12

This example illustrates how banks earn income directly from their reserve holdings at the central bank. The incentive to earn this interest influences their lending decisions and overall capital allocation within the financial system.

Practical Applications

Interest on reserves is a critical tool in modern monetary policy, particularly for central banks operating with ample reserves in the banking system. One significant application is its role in guiding the federal funds rate. By adjusting the rate paid on reserves, the Federal Reserve can effectively steer the federal funds rate within its target range, influencing borrowing costs for banks and, indirectly, for consumers and businesses7.

Furthermore, interest on reserves plays a key role in managing the large volumes of reserves created through unconventional policies like quantitative easing. During periods of quantitative easing, the central bank expands its balance sheet by purchasing assets, which injects significant reserves into the banking system. Paying interest on these reserves helps to prevent excessive lending and potential inflation by encouraging banks to hold onto the funds rather than lending them out immediately6. This allows the central bank to provide necessary liquidity while maintaining control over the short-term interest rate target5.

Limitations and Criticisms

While interest on reserves is a powerful monetary policy tool, it is not without limitations or criticisms. One common critique centers on the potential for central banks to incur losses, especially during periods of rising interest rates. If the interest paid on reserves exceeds the income earned from the central bank's assets (such as government securities purchased during open market operations), the central bank may experience negative remittances to the Treasury4.

Some critics also argue that paying interest on reserves can lead to the central bank becoming more deeply involved in financial markets and potentially influencing the allocation of credit, which they believe extends beyond the central bank's traditional functions of stabilizing the nominal price level and acting as a lender of last resort3. Additionally, concerns have been raised that discontinuing interest on reserves could penalize banks, disproportionately affecting smaller institutions, and potentially hindering their ability to supply credit to the economy2.

Interest on Reserves vs. Federal Funds Rate

While closely related, interest on reserves and the federal funds rate are distinct concepts in monetary policy.

FeatureInterest on ReservesFederal Funds Rate
Payer/ReceiverPaid by the central bank to commercial banks.Charged by one commercial bank to another.
PurposeDirectly influences banks' incentive to hold reserves; sets a floor for short-term rates.The target rate for overnight interbank lending of reserves.
ControlDirectly set by the central bank's governing body.Market-determined rate that the central bank aims to influence.
Impact on BanksIncome for banks holding reserves.Cost of borrowing or income from lending for banks.

The interest on reserves rate acts as a crucial lever for the central bank to manage the federal funds rate. By setting the interest rate on reserves, the central bank provides a benchmark below which banks are unlikely to lend their reserves in the federal funds market, thereby helping to keep the federal funds rate within its desired target range1. Confusion often arises because the interest on reserves rate is a primary tool used to achieve the federal funds rate target, making them functionally interdependent in the current monetary policy framework.

FAQs

Q: Why do central banks pay interest on reserves?
A: Central banks pay interest on reserves primarily to manage short-term interest rates and control the money supply. By adjusting this rate, they influence how much commercial banks lend versus how much they hold as reserves, thereby impacting economic activity and inflation.

Q: Does interest on reserves affect the average person?
A: Indirectly, yes. Changes to the interest on reserves rate can influence the federal funds rate, which in turn affects other lending rates in the economy, such as those for mortgages, car loans, and business credit. This can impact borrowing costs and the availability of credit for consumers and businesses.

Q: Are all reserves paid interest?
A: In many central banking systems, including the Federal Reserve, interest is paid on both required reserves (the minimum amount banks must hold) and excess reserves (any reserves held above the required amount).

Q: Did central banks always pay interest on reserves?
A: No. Historically, many central banks, including the U.S. Federal Reserve, did not pay interest on reserves. The Federal Reserve only began paying interest on reserves in October 2008 in response to the financial crisis to enhance its control over the federal funds rate and manage the significant increase in bank reserves.