Excess Reserves
What is Excess Reserves?
Excess reserves are the funds a bank holds above its required reserves, which are available to lend out.
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.
Excess Reserves: a worked example
A firm deposits $10 million of currency and the required reserve ratio is 10 percent. Required reserves are 0.10 × $10 million = $1 million, so excess reserves are $10 million − $1 million = $9 million. That $9 million is what this single bank can lend. For the banking system the money multiplier is 1 ÷ 0.10 = 10, so $9 million of excess reserves supports up to 10 × $9 million = $90 million in new loans and deposits beyond the original deposit. Now let the bank park $2 million rather than lending it. Excess reserves actually lent fall to $7 million, and maximum new money falls to 10 × $7 million = $70 million. Holding back $2 million erased $20 million of potential money creation, which is how idle balances weaken the multiplier process.
The mistake students make with excess reserves
The required ratio gets applied to the wrong base. Given $60 million in demand deposits and $9 million in total reserves at a 10 percent ratio, students compute required reserves as 0.10 × $9 million = $900,000 and report $8.1 million of excess reserves. Required reserves are a percentage of deposits, not of reserves, so the right figures are 0.10 × $60 million = $6 million required and $9 million − $6 million = $3 million excess. Read the balance sheet headings before multiplying, since deposits sit on the liability side and reserves on the asset side.
Excess Reserves questions
How do you calculate excess reserves?
Excess reserves equal total reserves minus required reserves, and required reserves equal the required reserve ratio times demand deposits. A bank with $50 million in deposits, a 20 percent ratio, and $14 million in total reserves must hold 0.20 × $50 million = $10 million, leaving $14 million − $10 million = $4 million in excess reserves available to lend out.
Why would a bank hold excess reserves instead of lending them?
Banks keep excess reserves when lending looks risky, when loan demand is weak, or when the return on holding reserves is close to what a loan would earn once default risk is counted. Precaution matters too. A bank that runs short at the end of the day has to borrow overnight at a cost, so carrying a cushion buys protection against a surge of withdrawals it cannot predict.
What happens to the money multiplier when banks hold excess reserves?
The realized multiplier falls below the simple 1 divided by the reserve ratio formula. That formula assumes every bank lends out all of its excess reserves and every borrower redeposits the funds. Each dollar held idle stops the chain of lending and redepositing early, so the actual expansion of the money supply comes out smaller. Cash the public holds outside banks shrinks it further.
Formula / Example
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Common comparisons
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