Changing the reserve requirements is perhaps the most powerful tool the Fed has to shift monetary policy. This tool regulates the amount of reserves required to be held in private banks. Changing reserve requirements can have a dramatic effect on the economy and the control of the money supply, but is rarely used.

Reserve requirements are the amount of funds that a depository institution must hold in reserve with regards to specific deposit liabilities. Banks and other depository institutions are required to keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as a balance with the Fed. Banks are required to hold a level of reserves equal to a proportion of deposits on their books. On average, banks hold even more reserve than they’re required to in order to clear overnight checks, restock ATMs, and make other payments.

These reserve determine the amount of money an institution can create through lending and investing. As an illustration on the power of the fractional reserve system, assume they current required reserve ratio is 10 percent. This means that a bank must set aside one dollar for every ten dollars on deposit. In other words, a bank cannot owe ten deposit dollars unless it holds one reserve dollar. Hence legal reserve requirements, combined with the given level of reserves, set limits on the amount of credit banks can offer.

Decreasing reserve requirements can lead to more money being injected into the economy by freeing up excess reserves that were previously set aside. This would generally lead to an expansion of bank credit and deposit levels and a decline in interest rates. Raising the requirements reduces the amount of funds that financial institutions could otherwise steer into the economy. The outcome would generally result in a reduction of the money stock and a rise in the cost of credit.

The reserve requirement ratio in a fractional reserve system is immensely powerful tool regarding the creation of money and hence the level of bank interest rates. It is important to understand the tool and its function but it is not only a tool scarcely used but is hardly even discussed by the Fed.

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