The Demand for Bank Loans Determines the Amount of Bank Reserves in the System
24 November 2016 | Pago Pago, American Samoa
As I have shown, the Fed does not control the amount of bank reserves in the system, but only really controls the Federal Funds Rate (FFR). But think of the FFR as a spigot for reserves in the system. Reduce it and banks can profitably loan more and borrow federal funds to cover those loans, thus increasing reserves and the money supply. Raise it and banks won't and reserves and the money supply will fall as bank loans are repaid and banks need not hold so many reserves.
It is the demand for bank loans at prevailing interest rates and the FFR that determines the amount of bank reserves in the system, not the other way around. Loan demand, at prevailing rates, and the FFR determine the money supply and the reserves required for it. Of course, banks can borrow and lend reserves at the interbank rate, but that doe not materially alter the analysis.
As bank loans are repaid, part of the money supply is destroyed and banks can develop excess reserves, unless both are obviated by replacement new loan volume. The point is loan demand, other things equal, determines reserve levels and the money supply, just as real investment substantially determines savings (to pay off bank loans made to invest).
Most people are confused on these matters because they don't understand monetary theory or how businesses and the banking system operate.