This week in my macro classes we covered the Federal Reserve (Fed) policy tools that are used to control the money supply in the economy. Ceteris paribus, the more money in the economy the more aggregatge demand (AD) we have. To see how this affects the economy, go to this post from back in 2009 Fed Officials Disagree On Threat Of Inflation. It shows a graph that explains how AD affects the economy.
The Fed sets the "required reserve ratio." This tells banks what percentage of their deposits they must keep on reserve. If they keep more on reserve than they have to, the extra amount is called excess reserves. The Fed now pays banks interest on these excess reserves.
But lately, banks have been keeping alot of excess reserves. This is because of the recession and the financial crisis. Banks want to make sure they have enough on reserve and are leary of lending too much money. The borrowers might not be able to pay it back. And businesses and consumers have been reluctant to borrow since they too fear they might not be able to pay it back.
To see a good chart on excess reserves, go to Why Are Banks Holding So Many Excess Reserves And Will Those Reserves Fuel Future Inflation? (from the blog "Carpe Diem" by economist Mark Perry). The chart shows that until about the middle of 2008, excess reserves were about zero. Now they are over $1 trillion.
But what might happen if the economy starts to improve and everyone gains confidence. Then banks start lending alot more money and spending increases rapidly. Could this cause inflation? One view is that the Fed just has to raise the interest rate it pays banks on excess reserves to keep them from lending too much. The banks will prefer to keep the excess reserves and earn income from the interest rate rather than lend it out. This would keep AD from increasing past the full-employment GDP into the steep part of the short-run aggregate supply curve (see the post I mention above).