If the Fed lowers the interest rate on excess reserves, banks will likely:

Question

BlackTom AI · Accepted Answer

Lowering the interest paid on excess reserves reduces the return banks receive for leaving funds idle at the Fed, so banks will shift those funds toward higher‑return uses and therefore hold fewer excess reserves.

1) Relevant concepts
- Required reserves: fraction of deposits banks must keep; set by the Fed and unaffected by IOER changes.
- Excess reserves: reserves above the required minimum that banks can hold at the Fed or lend out.
- Interest on excess reserves (IOER): the rate the central bank pays on reserves; it affects the opportunity cost of lending versus holding reserves.

2) Step‑by‑step reasoning
- Before the change, a dollar of excess reserve yields IOER r_e. If r_l is the return on lending or other investments, banks compare r_e and r_l when deciding whether to hold reserves or lend.
- If the Fed lowers r_e, the return from holding excess reserves falls relative to r_l.
- With lower compensation for idling funds, banks have a stronger incentive to convert excess reserves into loans, securities, or interbank lending where returns are higher.

3) Numerical illustration (intermediate steps)
- Suppose initially IOER r_e = 1% and lending return r_l = 4%. The incentive to lend (+3 percentage points) already exists.
- If the Fed cuts IOER to 0.25%, the incentive increases to +3.75 percentage points (4% − 0.25%).
- That larger spread encourages reallocation from excess reserves into loans/investments, reducing excess reserves held.

4) Why the correct answer is correct
- Lower IOER makes holding excess reserves relatively less attractive, so banks will reduce excess reserves and increase lending or asset purchases.

5) Why the other options are incorrect
- (a) not change excess reserves: incorrect because the change in IOER alters incentives and will typically change behavior.
- (c) hold more excess reserves: wrong direction—lower IOER reduces the attractiveness of holding reserves.
- (d) increase required reserves: incorrect because required reserves are set by regulation/the Fed, not by banks’ reactions to IOER; a change in IOER does not raise the required reserve ratio.

Conclusion: Banks will likely hold fewer excess reserves, so the correct choice is b.

If the Fed lowers the interest rate on excess reserves, banks will likely:Single choice

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