Reserve requirements - Definition and Overview

Reserve requirements, a tool of monetary policy, are computed as percentages of deposits that banks must hold as vault cash or on deposit at the central bank (in the United States in a Federal Reserve Bank), rather than, perhaps, lend out. Reserve requirements represent a cost to the banking system. Bank reserves, meanwhile, are used in the day-to-day implementation of monetary policy by the Federal Reserve.

As of 2004, in the United States, the reserve requirement are 10% on "transaction deposits" (component of money supply "M1"), and zero on time deposits and all other deposits.

As "a tool of monetary policy", they are one way of influencing the country's financial behavior, borrowing, and interest rates.

Reserve Requirements and Money Creation

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

Reserve Requirements on Deposits

United States reserve requirements on bank and thrift deposits. ([1] (http://www.federalreserve.gov/monetarypolicy/reservereq.htm))

1. Total transaction accounts consists of demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturing in seven days or less.

See also

• Bank regulation
• Monetary policy of central banks
• Money creation
• Money supply
• Reserves

External links

• Reserve Requirements - Fedpoints - Federal Reserve Bank of New York (http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html)

Articles

• Hussman Funds - Why the Federal Reserve is Irrelevant - August 2001 (http://www.hussmanfunds.com/html/fedirrel.htm)