Excess Reserves vs Reserve Requirement
Excess Reserves and Reserve Requirement are two Money & Monetary Policy concepts in AP Economics that students often mix up. Excess reserves are the funds a bank holds above its required reserves, which are available to lend out. The reserve requirement is the percentage of deposits that banks are legally required to hold as reserves rather than lend out. Here is how they compare side by side.
Banks create new money by lending excess reserves, which drives the money multiplier process. The central bank can change excess reserves through open market operations. When banks hold large excess reserves, the multiplier weakens.
When the Fed lowers the reserve requirement, banks can lend more, increasing the money supply through the money multiplier effect. Raising it reduces lending and tightens credit. This tool is rarely changed in modern U.S. monetary policy due to its drastic impact.
Excess Reserves vs the Reserve Requirement: A Dollar Balance and a Rule
| Excess Reserves | Reserve Requirement | |
|---|---|---|
| What it is | The amount a bank holds above what it must hold | A rule stating the fraction of deposits a bank must keep |
| Units | Dollars | A percentage of checkable deposits |
| Who determines it | The bank, through how much it has lent | The central bank, by regulation |
| Relationship to lending | The pool the bank is still free to lend | The share of each deposit that cannot be lent |
| What makes it change | New deposits, new reserves, or new loans | Only a decision by the central bank |
| Role in deposit expansion | The starting fuel for the process | The denominator that fixes the multiplier |
| Where it appears on a T-account | Part of the reserves line among the assets | Not a line at all; it splits the reserves line in two |
The requirement is a rule; excess reserves are what the rule leaves over
Start with a bank holding $2,000 in checkable deposits. Suppose the required reserve ratio is 10 percent, an illustrative figure picked to keep the arithmetic clean rather than a rate any central bank is committed to. Required reserves are then 10 percent of $2,000, which is $200. If the bank is actually sitting on $500 of total reserves, the remaining $300 is excess. That $300 is the only part it can lend, and lending it is how the bank earns. Raise the illustrative ratio to 20 percent and required reserves jump to $400, so excess reserves collapse to $100 without a single dollar leaving the building. Nothing about the bank changed. The rule did. Run it the other way and a 5 percent ratio pushes required reserves down to $100, freeing $400 to lend. This is why the two ideas sit at different levels of the same sentence. One is a percentage a regulator picks. The other is a dollar balance that falls out of that percentage once you know what the bank holds and what it owes depositors. Practise both calculations at /calculate/required-reserves and /calculate/excess-reserves, because exam questions hand you deposits and total reserves and expect you to produce the pair.
The ratio caps how far one dollar of reserves can travel
The reserve requirement does a second job that excess reserves cannot do. It sets the size of the money multiplier. In the simple model the multiplier equals one divided by the required reserve ratio, so a 10 percent ratio gives a multiplier of 10 and a 20 percent ratio gives a multiplier of 5. Excess reserves supply the fuel; the ratio decides how far that fuel goes. Take the same bank with $300 of excess reserves under the 10 percent illustrative ratio. It lends the $300, the borrower spends it, the receiving bank keeps $30 and lends $270, and the chain continues. Added across the whole banking system, checkable deposits can rise by at most $300 times 10, or $3,000. Under a 20 percent ratio the identical $300 supports at most $1,500. The word maximum carries weight here. Every dollar the public keeps as cash instead of depositing, and every dollar a bank chooses to leave idle, drops out of the chain and pulls the real expansion below the ceiling. A central bank can also set the ratio to zero, at which point the rule stops binding and banks hold reserves purely for their own payment and liquidity needs. The full chain is laid out at /calculate/maximum-checkable-deposit-expansion.
Frequently asked questions
What is the difference between required reserves and excess reserves?
Required reserves are the dollars a bank must legally hold against its deposits, and excess reserves are whatever it holds beyond that floor. Only excess reserves can be lent, which makes them the part that feeds new loans and new deposits.
How do you calculate excess reserves?
Subtract required reserves from total reserves, where required reserves equal the required reserve ratio multiplied by checkable deposits. A bank with $800 of total reserves and $4,000 of deposits facing a 10 percent ratio holds $400 required and $400 excess.
Why would a bank hold excess reserves instead of lending them?
Because reserves protect it against unexpected withdrawals and payment demands, and because a central bank may pay interest on reserve balances. When the return on holding reserves comes close to what a safe loan pays, keeping money idle costs the bank very little, so excess reserves can stay large for long stretches.
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