The Federal Reserve, or Central Bank, is the banking system’s bank. It is the lender of last resort. It is through the Central Bank that banks settle their accounts with each other. The central bank serves as a clearinghouse for checks written by depositors, and it holds the commercial banks’ reserves. Bank reserves (vault cash, and deposits by banks at the Central Bank or the Fed) are monies held out of circulation by banks to satisfy the Fed’s reserve requirements and the currency demand by the public. Excess reserves are those held above the legal reserve requirements to handle uncertain demand. Bank deposits not held in (required plus excess) reserves are used to make loans and earn interest.
When banks make loans, they do not actually lend out the equivalent in cash but instead create on their balance sheet a loan asset and an equal liability called a demand deposit. Such lending by banks is limited only by reserve requirements (set by the Fed) and the cash they need to satisfy cash withdrawal demand by their customers. As these loans are then re-deposited by the borrower, the multiplier process continues as fractional reserves are held back and the balance is “lent” out again.
So when the Fed begins to pay interest on excess reserves, it not only reduces lending, but shrinks the money supply and the liquidity it represents by a multiple of the funds not lent.