reserve requirement

Examples of reserve requirement in the following topics:

• The Fractional Reserve System

  • The fraction of deposits that a bank must hold as reserves rather than loan out is called the reserve ratio (or the reserve requirement) and is set by the Federal Reserve.
  • If, for example, the reserve requirement is 1%, then a bank must hold reserves equal to 1% of their total customer deposits.
  • Banks can also choose to hold reserves in excess of the required level.
  • Any reserves beyond the required reserves are called excess reserves.
  • Excess reserves plus required reserves equal total reserves.

• Example Transactions Showing How a Bank Can Create Money

  • Assume that all banks are required to hold reserves equal to 10% of their customer deposits.
  • Anderson and Brentwood both operate in a financial system with a 10% reserve requirement.
  • Anderson will loan out the maximum amount (90%) and hold the required 10% as reserves.
  • Thus, with a required reserve ratio of 0.1, an increase in reserves of $1 can increase the money supply by up to $10 .
  • The graph shows the total amount of money that can be created with the addition of $100 in reserves, using different reserve requirements as examples.

• The Reserve Ratio

  • The reserve ratio is the percentage of deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned.
  • The ratio is a set percentage of customer deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned.
  • Required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank.
  • The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impact the amount of loanable funds available .
  • The conventional view in economic theory is that a reserve requirement can act as a tool of monetary policy.

• The Money Multiplier in Theory

  • That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves; this multiple is the reciprocal of the reserve ratio.
  • We start with the reserve ratio requirement that the the fraction of deposits that a bank keeps as reserves is at least the reserve ratio:
  • Theoretically, then, a central bank can change the money supply in an economy by changing the reserve requirements.
  • A 10% reserve requirement creates a total money supply equal to 10 times the amount of reserves in the economy; a 20% reserve requirement creates a total money supply equal to five times the amount of reserves in the economy.
  • The graph shows the theoretical amount of money that can be created with different reserve requirements.

• The Creation of the Federal Reserve

  • The Fed has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations.
  • Commercial banks are required to hold a certain proportion of their deposits in reserves and not lend them out.
  • This proportion is called the reserve requirement and is controlled by the Fed.
  • By changing the reserve requirement, the Fed can impact the amount of money available for lending, and by extension, spending and investment.
  • Commercial banks are required to have a certain amount of reserves on hand at the end of each day.

• The Money Multiplier in Reality

  • First, some banks may choose to hold excess reserves.
  • During this time, the relationship between reserves, reserve requirements, and the money supply was relatively close to that predicted by economic theory.
  • The presence of these excess reserves suggests that the reserve requirement ratio is not exerting an influence on the money supply.
  • Imagine that the reserve requirement ratio is 10% and a customer deposits $1,000 into a bank.
  • After the financial crisis the monetary base increased dramatically: the result of banks starting to hold excess reserves as well as the central bank increasing the supply of reserves.

• Executing Expansionary Monetary Policy

  • Central banks can increase the money supply through open market operations and changes in the reserve requirement.
  • Banks and other depository institutions are required to keep a certain amount of funds in reserve in order to maintain enough liquidity to meet unexpected demand for deposits.
  • By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.
  • In an expansionary policy regime, the Fed would reduce the reserve requirement.
  • As a result, the bank may have more reserves than required.

• Money in the U.S. Economy

  • "The Fed," as it is commonly known, includes 12 regional Federal Reserve Banks and 25 Federal Reserve Bank branches.
  • All nationally chartered commercial banks are required by law to be members of the Federal Reserve System; membership is optional for state-chartered banks.
  • The Federal Reserve Board of Governors administers the Federal Reserve System.
  • Raising reserve requirements forces banks to withhold a larger portion of their funds, thereby reducing the money supply, while lowering requirements works the opposite way to increase the money supply.
  • Banks often lend each other money over night to meet their reserve requirements.

• The Federal Funds Rate

  • The Federal Funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve.
  • In the US, banks are obligated to maintain certain levels of reserves, either in the form of reserves with the Fed or as vault cash.
  • These daily activities change their ratio of reserves to liabilities.
  • If, by the end of the day, the bank's reserve ratio has dropped below the legally required minimum, it must add to its reserves in order to remain compliant with the law.
  • Banks do this by borrowing reserves from other banks with excess reserves, and the weighted average of these interest rates paid by borrowing banks determines the federal funds rate.

• Structure of the Federal Reserve

  • The Federal Reserve (the Fed) was designed to be independent of the Congress and the government.
  • Twelve regional Federal Reserve Banks located in major cities throughout the nation, which divide the nation into twelve Federal Reserve districts.
  • The Federal Reserve Banks act as fiscal agents for the U.S.
  • Numerous other private U.S. member banks, which own required amounts of non-transferable stock in their regional Federal Reserve Banks.
  • Recall the structure of the Federal Reserve System of the United States