An increase in the interest rate on excess reserves will:

Question

BlackTom AI · Accepted Answer

Banks compare the rate they can earn by holding reserves at the Fed (the interest on excess reserves, IOER) with the rate they can earn by lending those reserves in the federal funds market. If IOER rises, holding reserves becomes more attractive, so banks demand a higher federal funds rate to be willing to lend.

1) Relevant concepts
- IOER: the interest the central bank pays on banks’ excess reserves.
- Federal funds rate: the overnight rate banks charge one another for reserves.
- Opportunity cost: banks will not lend reserves at a rate below what they can safely earn by keeping them at the Fed.

2) Step-by-step reasoning
- Initially banks decide whether to keep excess reserves or lend them overnight.
- If IOER increases, the return from simply leaving reserves at the Fed rises.
- To persuade banks to lend instead of holding reserves, borrowers in the fed funds market must offer a higher rate.
- As a result, the equilibrium federal funds rate increases toward the higher IOER (IOER effectively sets a floor).

3) (No numeric calculation required) The key comparison is between two rates: the new higher IOER and the prevailing fed funds rate. The fed funds rate will move up until it is at or near IOER (adjusted for market frictions).

4) Why the correct answer is correct
Because IOER raises the opportunity cost of lending reserves, banks require higher compensation to lend, pushing the federal funds rate up. In many systems IOER functions as a floor for the fed funds rate.

5) Why other options are incorrect
- b (decrease): Wrong — a higher IOER makes holding reserves more attractive, not less, so it raises, not lowers, the fed funds rate.
- c (eliminate excess reserves): Wrong — higher IOER encourages banks to hold, not eliminate, excess reserves.
- d (not affect): Wrong — IOER directly affects banks’ incentives and thus the federal funds rate.

Conclusion: An increase in IOER will increase the federal funds rate; final answer: a. increase the federal funds rate.

An increase in the interest rate on excess reserves will:Single choice

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