Interest rates on Required Reserve Balances

: Interest rates on Required Reserve Balances and excess balances

How the Federal Reserve utilize Interest rates on Required Reserve Balances and excess balances to control the economy’s growth.

Analysis

The interest rate on required reserves (IORR rate) is determined by the Board and is intended to eliminate the implicit tax effectively that reserve requirement used to impose on depository institutions. According to the Policy Normalization Principles and Plans adopted by the Federal Open Market Committee, during monetary policy normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the

IOER rate. The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve Banks to pay interest on balances held by or on behalf of depository institutions at Reserve Banks, subject to regulations of the Board of Governors, effective October 1, 2011. Interest in Reserves is the newest and most frequently used tool given to the Fed by Congress after the Financial Crisis of 2007-2009.

Conclusion

Interest on reserves is paid on excess reserves held at Reserve Banks.  The Federal Reserve requires banks to hold a percentage of their deposits on reserve. In addition to these reserves, banks often hold extra funds on reserve. The current policy of paying interest on reserves allows the Fed to use interest as a monetary policy tool to influence bank lending. By lowering the interest rate paid on excess reserves, the Federal Reserve creates more significant incentives for banks to lend their excess reserves. Under the policy, banks are more likely to lend money rather than hold it in reserve to make more money creating an expansionary policy. Similarly, the Federal Reserve can increase the interest rate paid on reserves to create an incentive for banks to hold more excess reserves and decrease lending under the contractionary policy.

 


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