The fact that banks are holding excess reserves indicates that loans are not being generated, preventing expansion of the money stock and retarding economic expansion.

Banks provide loans when they are unable to make money on excess reserves. However, in October of 2008, the Fed removed the incentive for banks to provide credit by paying interest on bank reserves. As a result, banks have little incentive to provide credit when the Fed payment of interest rate is higher than the market interest rate.

When banks did not earn interest on reserves, they had an incentive to lend to the public. What is also interesting is that most of the excess reserves that banks hold are loans from the Fed to the banks.

Thus, the Fed to rewarded banks with bailed out funds and agreed to pay interest on the money that they loaned to the banks and close to zero interest rate. No wonder the banks have become so profitable after the economic collapse.

The Fed, however, has not provided the average citizen-mortgage holder with the same advantages that it has provided to financial institutions. In fact, the policy change of paying interest on bank reserves contributes to illiquidity, preventing consumers and businesses from acquiring credit.

Here is how high excess bank reserves affect commercial credit (CC). Lets assume that the money supply is currency in circulation plus demand deposits (M=CU+DD) and high-powered money is currency plus bank reserves (H=CU+RE). Commercial credit, therefore, is the difference between the money supply and high-powered money (CC=M-H). When RE increases H also increases, leading to a reduction in available credit.

When banks could not earn a return on excess reserves, they had to loan or invest the excess reserves and the economy would expand, creating opportunities and jobs.

It appears that Obama’s economic advisors and the Fed are not concern in expanding the economy and improving employment, since as long as they allow the Fed to pay interest on bank reserves, banks have little incentive to expand credit.

Bank reserves are a function of market interest rates. That is, an increase in the market interest rate would cause banks‘ to loan out their excess reserves. As a result more money would be available for investment in plants, equipment, and construction. However, high interest rates would mean that the government would have be pay more on the national debt.

Thus, it appears that the administration and the Fed are faced with conflicting policy objectives. The Fed by keeping interest rate low and paying off the banks (interest on reserves) ensures low interest rate on government debt. However, if the Fed do not pay interest on bank reserves, a higher market interest rate would prevail and banks would be forced to invest excess reserves leading to more employment.

It appears, in spite of the Fed and the administration rhetoric, that they’ve chosen to sacrifice liquidity and employment in favor of preventing higher interest payment on massive fiscal expansion. And, the voters are beginning to figure it out.