Which of the following is a policy instrument central banks may use to influence bank lending by paying interest on reserves?

• A. Open market operations
• B. Reserve requirements
• C. Discount window
• D. Interest on reserves

Answer: (D)

Paying interest on reserves is a policy tool that directly affects the opportunity cost of holding reserves at the central bank. By setting the return on reserves, the central bank creates a floor for short-term rates and shapes banks’ incentives to lend versus hold funds. If the interest paid on reserves is high, banks earn more by keeping money as reserves instead of making loans, which can dampen credit creation. If the rate is lower, banks are more inclined to lend because the payoff from holding reserves is reduced. This mechanism is especially powerful when the system has ample reserves, helping the central bank steer the policy rate and the overall lending pace. Other tools work differently: open market operations change the total reserves directly, reserve requirements set mandatory holdings, and the discount window provides liquidity access. The tool that uses the return on reserves to influence lending is the one described here.