Ignoring any reserve requirements, bank reserves will be higher than otherwise if the central bank pays a positive return on overnight reserves held by the commercial banks equal to its current policy rate.
Answer: True
The answer is True.
This question was clearly related to the Question 2 and so some of the essential information required to understand the answer here is presented there.
The payment of a positive return on overnight reserves equal to the current policy rate will significantly reduce interbank activity. Why? Because the banks will not have to worry about earning non-competitive returns on excess reserves. When there are excess reserves in the system, which means the level of reserves is beyond that desired by the banks for clearing purposes, the banks which hold excesses seek to lend them out on the interbank (overnight) market.
In the absence of a support rate (positive return on overnight reserves) and any central bank liquidity management operations (open market purchases in this case), the competition in the interbank market will drive the market rate of interest down to zero on overnight funds. It should be noted that these transactions between the banks will not eliminate a system-wide excess reserve situation.
The competition will redistribute the excess between banks but will not eliminate it. A vertical transaction between the government and non-government sectors is the only way such an excess can be eliminated.
Please see the suite of blogs - Deficit spending 101 - Part 1 - Deficit spending 101 - Part 2 - Deficit spending 101 - Part 3 - for a detailed explanation of the difference between vertical transactions (between the government and non-government sectors) and horizontal transactions (between non-government entities).
Clearly, the central bank loses control of its monetary policy setting in this case (unless the target is a zero short-term interest rate) unless it steps in and eliminates the excess reserves by selling government debt to the banks. This provides the banks with an interest-bearing financial asset in exchange for the zero-interest bearing reserves.
Once the central bank offers a support rate the situation changes If the support rate on overnight reserves is set equal to the current policy rate then the banks have no incentive to engage in interbank lending. Some banks may still seek overnight funds in the interbank market if they are short of reserves but in general activity in that market will be significantly reduced.
Further, the opportunity cost of holding excess reserves is eliminated and so the banks have less need to minimise their holdings of reserve balance each day.
Any bank with reserves in excess of their short-term perceived clearing house requirements will still earn the market rate of interest on them.
As a consequence, the incentive to lend these funds is substantially reduced. Banks would only participate in interbank market if the rate they could lend at was above the market rate and below the central bank penalty rate.
So in this case, banks will tend to hold more reserves than otherwise to make absolutely sure they never need to access the discount window offered by the central bank which carries the penalty.
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