University of Central Florida (UCF) ECO3203 Intermediate Macroeconomics Practice Exam 1

When the Federal Reserve increases the interest rate paid on reserves, banks have a greater incentive to hold onto excess reserves. This is because they can earn a higher return by keeping those funds in reserve rather than lending them out. As a result, banks will tend to hold more excess reserves.

Holding more excess reserves means that the amount of money banks are willing to lend out decreases. The money multiplier, which reflects the relationship between the amount of reserves banks hold and the total amount of money created in the economy, is inversely related to the level of excess reserves. When banks retain a larger portion of their reserves instead of lending them out, it leads to a decrease in the money multiplier.

Thus, with an increase in the interest rate paid on reserves, banks holding more excess reserves contributes to a decrease in the money multiplier.