Controlling reserves either through availability or the rate at which reserves are carried is the backbone of the Feds forces. Understanding the reserves system is key to understanding why the Fed carries so much control over the whole financial system.
Reserve requirements are the percentage of deposits that depository institutions must hold in reserve and not lend out. All depository institutions, including; commercial banks, savings institutions, credit unions, and foreign banking entities are required to hold reserves against certain types of deposits that they report as liabilities on their balance sheets. Depository institutions may hold their required reserves as:
- Vault cash
- Deposits at their regional Federal Reserve Bankv
Depository institutions normally keep a certain level of vault cash on hand to meet the operating needs of their offices and branches. Required reserves above the amount of vault cash are met by holding reserve balances with Federal Reserve Banks. Depository institutions prefer to minimize the amount of reserves they hold, because neither vault cash nor Reserves at the Fed generate interest income for the institution.
At present, reserve requirements aid in the conduct of open market operations by helping to ensure a stable, predictable demand for reserves; they thereby increase the Federal Reserve’s control over short-term interest rates.
Reserve requirements shape the way our banking system can create transaction deposits. When the reserve requirement on certain deposits is set at 10%, a bank that receives a net increase of $1000.00 in deposits can lend out $900.00 of that deposit. The individual or entity that borrows the $900.00 can then write a check to yet someone else who in turn deposits the $900.00 in their bank. As those funds are lent out, they create additional deposits in the banking system. The bank that receives that deposit can loan out $810.00 of that $900.00,which maintains the 10% reserve requirement. This progression continues and the banking system has the capacity to expand the initial deposit of $1000.00 into a maximum of $10,000 of new money.
A higher reserve requirement would result in lower maximum amount of new money that can be created. Generally leading to a reduction in economic activity. A lower reserve requirement would result in a greater multiple and more funds being created. Generally leading to greater potential economic activity.
The increase in deposits affects the overall money stock by increasing the various categories of deposits and currency in the hands of the public. Increasing the reserve requirement ratios reduces the volume of deposits that can be supported by a given level of reserves and, in the absence of other actions, reduces the money stock and raises the cost of credit. Decreasing the ratios leaves depositories initially with excess reserves, which can induce an expansion of bank credit and deposit levels and a decline in interest rates.
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