Excess Reserves vs Federal Funds Rate

Every idle dollar costs the overnight rate, which is why banks lend them out at all

Excess reserves earn a bank little, and the overnight rate measures what that costs. Start with a bank holding $600 million of checkable deposits under a 10 percent requirement. Required reserves are $60 million. If the bank is actually sitting on $95 million, then $35 million is excess. Now price the idleness: at an overnight rate of 5 percent, lending that $35 million to another bank would earn $1.75 million across a year, so leaving it parked is a decision with a number attached. That number is the whole reason an overnight market exists. Banks whose customers deposited more than they withdrew end the day with a surplus. Banks whose customers did the reverse end the day below the balance they need and have to close the gap before the books settle. The first group lends, the second borrows, and the price they agree on is the federal funds rate. Turn the balance sheet around to see the other side: a bank ending the day $12 million short can borrow overnight or sell assets in a hurry, and it picks whichever costs less. One term names a quantity a bank happens to hold; the other names the price at which that quantity changes hands. Practice the subtraction at /calculate/excess-reserves.

An overnight loan between two banks moves reserves without creating any

Interbank lending redistributes reserves rather than manufacturing them. When Bank A lends $35 million of excess reserves to Bank B, Bank A's reserve account falls by $35 million and Bank B's rises by the same amount. Total reserves in the system are exactly where they were, the monetary base has not moved, and no household or firm has gained a deposit, so the money supply is unchanged as well. Only the central bank can change the total, by buying or selling securities or by lending at its own window. That fact ruins a popular wrong answer. Asked what happens to the money supply when banks trade reserves overnight, students reach for the money multiplier and report an expansion. The multiplier applies when a bank lends to the public and the borrower's spending arrives as a deposit at some other bank, which starts a fresh round. An interbank loan never leaves the banking system, so no new deposit appears and no round begins. What the overnight market does change is which bank holds the reserves, and therefore whether Bank B must shrink its lending to the public tomorrow. The effect on the money supply is real but indirect, running through lending capacity rather than through arithmetic. Check the mechanism you actually need at /glossary/money-multiplier.

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