Possible Excess Reserve

Our analysis proceeded on the assumption that the commercial banks follow their legal reserve requirements to the letter. What would happen if the bank decided to keep rather than lend the new reserves? Then the whole process , of multiple deposit creation would stop dead, with no expansion of deposits at all. This decision would of course make no sense ‘for the bank, Because the bank earns no interest on reserves, it would lose interest payments on the $900.

So as long as the interest rate on investments is above the interest rate on reserves (set at zero), banks have , a strong incentive ,to avoid holding any excess, reserves. In certain situations, it might be reasonable to have excess reserves. During the Great Depression, interest rates fell to 0.1 percent per year, so banks during this period often held significant excess re- , serves. In 1999. short-term interest rates were essentially zero in Japan, and banks had significant quantities of excess -reserves, In such pathological situations, central-bank control of the money supply becomes much more difficult.

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