Ample Reserves vs Limited Reserves, Explained for AP Macro

In an ample reserves framework, banks hold so many reserves that small changes in the quantity of reserves no longer move the federal funds rate, so the Federal Reserve steers that rate by setting administered rates, chiefly the interest it pays on reserve balances (IORB). In the older limited reserves framework, reserves were scarce, and the Fed moved the federal funds rate by using open market operations to add or remove reserves. AP Macro asks you to tell the two apart, draw the reserve market graph for each, and name the tool that works in each one.

The market for reserves

Both frameworks are drawn on the same graph, so start there.

Reserves are the balances banks hold in their accounts at the Fed, plus cash in their vaults. The federal funds rate is the rate banks charge each other to borrow reserves overnight. The reserve market graph puts the federal funds rate on the vertical axis and the quantity of reserves on the horizontal axis.

• Supply of reserves is a vertical line, because the Fed decides how many reserves exist through its purchases and sales of securities.
• Demand for reserves slopes down at first: when the federal funds rate is high, holding reserves has a high opportunity cost, so banks economize on them. When the rate falls, banks are willing to hold more.

The key feature is what happens at the bottom of the demand curve. Since 2008 the Fed has paid interest on reserves. A bank will never lend reserves to another bank for less than it can earn by leaving them at the Fed. So the demand curve flattens out at the interest on reserves rate. Once banks have all the reserves they need for payments and safety, extra reserves just sit in their accounts earning IORB, and the demand curve runs horizontally to the right.

That kinked demand curve is the whole story. Which framework the Fed is in depends on where the vertical supply line crosses it. Drag the supply line and the IORB rate yourself in the reserve market sandbox.

See it move

Make it move

The reserve market under limited reserves, where the supply of reserves sets the policy rate. Tap it to drag the curves, open the full version, or put it on your own site free, or turn it into a five-minute class activity.

The limited reserves framework

In a limited reserves system, the supply of reserves crosses demand on its downward sloping part. Reserves are scarce, banks actively borrow and lend them overnight, and the quantity matters for the price.

This is the framework the Fed used before 2008. Its main tool was open market operations:

• Open market purchase. The Fed buys securities, the supply of reserves shifts right, and the equilibrium slides down the demand curve to a lower federal funds rate.
• Open market sale. The Fed sells securities, the supply of reserves shifts left, and the federal funds rate rises.

The other two classic tools work through the same graph. Changing the reserve requirement changes how many reserves banks must hold, which shifts reserve demand. Changing the discount rate changes the cost of borrowing directly from the Fed. The money multiplier explainer shows the deposit expansion story that goes with this framework, and the open market operations guide works a full example.

How the Fed moved to ample reserves

Several changes, in order, moved the U.S. banking system from scarce reserves to plentiful ones:

1. October 2008. The Fed began paying interest on reserves, which put a floor under the demand for reserves.

2. 2008 onward. Large scale asset purchases, often called quantitative easing, paid for trillions of dollars of securities with newly created reserves. The supply of reserves moved far to the right.

3. January 2019. The Federal Open Market Committee announced that it intended to keep implementing policy in a regime with an ample supply of reserves.

4. March 2020. The Fed set reserve requirements to zero, which removed the requirement for any U.S. bank to hold reserves against its deposits.

5. 2021. The Fed combined its separate rates on required and excess reserves into a single rate, interest on reserve balances (IORB).

The ample reserves framework

With ample reserves, the vertical supply line crosses demand on its flat part. Now the graph behaves very differently.

Open market operations barely move the rate. Shift the supply of reserves left or right and it still crosses the flat part of demand. The federal funds rate stays at about the same level. Adding or removing a modest amount of reserves changes nothing important, because no bank is short of reserves to begin with.

Administered rates move the rate. The Fed sets the federal funds rate's target range, a band 0.25 percentage point wide, and then sets its own rates to keep the market rate inside it:

• Interest on reserve balances (IORB). The rate the Fed pays banks on their reserves. Raising IORB shifts the flat part of the demand curve up, and the federal funds rate rises with it. Lowering IORB does the reverse. This is the main tool.
• Overnight reverse repurchase agreement (ON RRP) rate. Some lenders in short-term markets, such as money market funds, cannot earn IORB because they do not hold reserve accounts. Through the ON RRP facility, they can lend to the Fed overnight at a rate the Fed sets, typically at the bottom of the target range. Few of them will lend to anyone else for less, which sets a floor under short-term rates.
• Discount rate. The rate the Fed charges banks to borrow directly, which sits above IORB and limits how high short-term rates can go.

The comparison federal funds rate vs IORB shows how the two rates relate, and discount rate vs IORB shows why one sits above the other.

Worked example: the same rate hike in each framework

Use hypothetical numbers. The federal funds rate is trading near 4.40%, and the Fed wants it near 4.65%, an increase of 0.25 percentage point.

Ample reserves. Banks hold $3 trillion of reserves. The Fed raises IORB from 4.40% to 4.65%.

Consider a bank with $100 million of reserves it does not need. At the old IORB, leaving the money at the Fed earns $100 million × 0.0440 = $4.40 million a year. Another bank offers to borrow it at 4.30%, which would earn only $100 million × 0.0430 = $4.30 million a year and carry the risk of lending to another bank. The first bank says no.

After the hike, the Fed pays $100 million × 0.0465 = $4.65 million a year. A borrower would have to offer close to that to attract the funds, and every lending bank faces the same arithmetic. The federal funds rate moves up by about the same 0.25 point the Fed raised IORB. The Fed did not have to sell a single security.

Now try an open market operation instead. Suppose the Fed sells $10 billion of securities. Reserves fall from $3,000 billion to $2,990 billion, a drop of $10 billion / $3,000 billion ≈ 0.33%. The supply line moves slightly left but still crosses the flat part of demand, so the federal funds rate does not change.

Limited reserves. Banks hold $40 billion of reserves, and demand slopes down at that quantity. The Fed sells $5 billion of securities. Reserves fall to $35 billion, a drop of 12.5%. Banks that are now short of reserves compete to borrow them, and the federal funds rate climbs along the downward sloping demand curve until it reaches the target. Here the quantity of reserves is the tool.

The contrast is the point of the example: the same goal takes a change in an administered rate under ample reserves, and a change in the quantity of reserves under limited reserves.

What AP Macro students need to know

The AP course treats monetary policy in topic 4.6 under both frameworks. The skills that matter:

• Identify the framework from the graph. If the supply of reserves crosses the sloped part of demand, it is limited reserves. If it crosses the flat part, it is ample reserves.
• Name the right tool. Limited reserves: open market operations, the reserve requirement, and the discount rate. Ample reserves: administered rates, mainly interest on reserves, along with the discount rate.
• Show the change. Under limited reserves, shift the vertical supply of reserves. Under ample reserves, shift the flat part of demand up or down by changing IORB.
• Finish the chain. In both frameworks the effect on the economy runs the same way. A lower federal funds rate lowers other interest rates, which raises investment and interest-sensitive consumption, shifts aggregate demand right, and raises real output and the price level. A higher rate does the reverse.

The money market graph and the money multiplier still appear in the course. They describe the same direction of policy using the quantity of money instead of the price of reserves.

How it shows up on the AP exam

Typical tasks ask you to draw a correctly labeled reserve market graph for one framework, show the effect of a stated policy action, identify which tool the Fed would use to reach a new target, or explain why an open market operation would or would not change the federal funds rate.

Common mistakes:

• Drawing reserve demand as a straight line. Under ample reserves it must have a flat section at the IORB rate.
• Shifting supply to raise the rate under ample reserves. A small shift in supply leaves the rate unchanged on the flat part.
• Calling IORB a rate banks pay. The Fed pays IORB to banks; banks pay the discount rate when they borrow.
• Labeling the vertical axis "interest rate" with no detail. Write "federal funds rate" on the reserve market graph.
• Assuming reserve requirements still bind. The Fed set them to zero in March 2020, and with reserves already ample, the quantity of reserves is no longer the tool that sets the rate.