Reserve Requirement
What is Reserve Requirement?
The reserve requirement is the percentage of deposits that banks are legally required to hold as reserves rather than lend out.
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.
Reserve Requirement: a worked example
A banking system holds $50,000 of total reserves under an 8% reserve requirement, so the multiplier is 1 / 0.08 = 12.5 and those reserves support $50,000 / 0.08 = $625,000 of checkable deposits. Suppose the central bank raises the requirement to 12.5%. The multiplier falls to 1 / 0.125 = 8, and the same $50,000 of reserves now supports only $50,000 / 0.125 = $400,000 of deposits, a contraction of $225,000. For a single bank with $300,000 of deposits, required reserves jump from 0.08 x 300,000 = $24,000 to 0.125 x 300,000 = $37,500, so a bank sitting on exactly $24,000 has to find $13,500 more by calling in loans or refusing new ones.
The mistake students make with reserve requirement
Writing that a higher reserve requirement gives banks more money to lend is the reversal graders see most. Reserves sound like the bank's own spending money, but required reserves are frozen and unavailable for lending, so raising the requirement tightens credit. The second error is applying the percentage to the wrong base. The requirement is a fraction of deposits, not of a bank's loans or total assets, so a bank with $300,000 of deposits under a 12.5% requirement must hold $37,500 no matter how large its loan book is.
Reserve Requirement questions
Why do central banks rarely change the reserve requirement?
Changing the requirement hits every bank in the system on the same day and forces immediate balance sheet adjustments, so even a small move can disrupt lending. Open market operations reach the same direction of change in fine increments and can be reversed the next morning. Central banks therefore keep the requirement stable and use bond purchases and sales for ordinary policy adjustments.
What happens to the money supply if the reserve requirement is lowered?
Lowering the requirement expands the money supply. Reserves that were locked up become excess reserves available for lending, and the money multiplier rises because it equals 1 divided by the requirement. Dropping a requirement from 12.5% to 8% lifts the multiplier from 8 to 12.5, so an unchanged $50,000 of reserves can support $625,000 of deposits instead of $400,000.
Where do banks keep their required reserves?
Required reserves sit either as vault cash at the bank or as deposits in the bank's account at the central bank. Both forms count toward meeting the requirement, and neither can be lent to customers while it is counted as required. Vault cash held by a bank is not part of the money supply, because the money supply counts only currency held by the public.
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