Question

In October $2008$, the Federal Reserve began paying interest on the amount of excess reserves held by banks. How, if at all, might this affect the multiplier process and the money supply?

Short answer

While federal reserve paying interest on excess reserve by banks will lead to the lower multiplier, this will happen because banks will have at least one source of interest income, rather than going out in the market and looking for a return on those deposits.

Step-by-step solution

Concept Introduction

The Federal Reserve will be able to increase its balance sheet as necessary to provide liquidity to facilitate financial stability while implementing monetary policy that is consistent with the System's macroeconomic objectives of maximizing employment and maintaining price stability.

Explanation

The Federal Reserve's decision to pay interest on excess reserves gives banks an incentive to hold onto more excess reserves rather than make loans with them.

This would slow down the multiplier process and decrease the money supply because a reduction in loans stops the multiple deposit creation.

Explanation

Money supply will increase a bit due to the interest income released by the federal reserve in the banking system.