Final answer:
An increase in the interest rate on reserves encourages banks to hold more reserves as they earn higher returns on deposits at the Fed. The Fed raises interest rates using open market operations, adjusting reserve requirements, and changing the discount rate to influence the federal funds rate.
Step-by-step explanation:
The question addresses the mechanism through which the Federal Reserve (commonly referred to as the Fed) influences the banking system to hold more reserves by adjusting the interest rate on reserves (IOR). When the Fed increases the IOR, banks tend to hold more reserves because they earn higher returns on the funds they keep deposited with the Federal Reserve, rather than lending them out.
To raise interest rates, the Fed can use several tools including open market operations, changing reserve requirements, or adjusting the discount rate. Open market operations involve the buying and selling of government securities to influence the level of reserves in the banking system. More specifically, by selling securities, the Fed absorbs reserves, which can lead to higher interest rates. Adjusting reserve requirements influences the amount of reserves banks need to hold; an increase in the requirement can lead to higher interest rates as banks have less money to lend out. The discount rate is the interest the Fed charges banks for loans, and increasing this rate can also raise the broader interest rates in the economy.
These actions together affect the federal funds rate, which is the target interest rate set by the Fed for lending between depository institutions. If the actual interest rates do not align with the Fed's targets, it can adjust the supply of reserves to ensure that its interest rate objectives are achieved.