The increase in deposits affects the money stock, because it is measured in several ways that primarily include various categories of deposits and currency in the hands of the public. Thus, even a small change in the reserve requirement ratio may have a relatively large effect on reserve requirements and the money stock.
There are several reasons why reserve requirements are not frequently changed, the most important of which is that open market operations provide a much more precise tool for implementing monetary policy.
The impact of changes in reserve requirements is difficult to estimate; each change has the potential to affect thousands of depository institutions in different ways, depending on each institution's deposit base. Changes in reserve requirements also typically lead to changes in pricing schedules for some bank services, because some bank fees and credits are set based on reserve requirements. The third monetary policy tool is the discount rate, the interest rate charged when depository institutions borrow overnight from the Federal Reserve discount window.
The Monetary Control Act of sets the statutory requirements for reserves. The greater the reserve requirement, the less money that a bank can potentially lend—but this excess cash also staves off a banking failure and shores up its balance sheet.
Still, when the reserve ratio increases, it is considered contractionary monetary policy, and when it decreases, expansionary. If the Federal Reserve decides to lower the reserve ratio through an expansionary monetary policy, commercial banks are required to keep less cash on hand and are able to increase the number of loans to give consumers and businesses.
This increases the money supply , economic growth and the rate of inflation. The Federal Reserve's monetary policy is one of the ways in which the U. It needs to balance economic growth with increasing inflation. If it adopts an expansionary monetary policy, it increases economic growth but also accelerates the rate of inflation. If it adopts a contractionary monetary policy, it seeks to reduces inflation but also inhibits growth.
The three ways in which the Federal Reserve achieves an expansionary or contractionary monetary policy include the use of the following:. The reserve ratio dictates the reserve amounts required to be held in cash by banks. These banks can either keep the cash on hand in a vault or leave it with a local Federal Reserve bank. The exact reserve ratio depends on the size of a bank's assets. The reserve ratio is calculated as:. When the Federal Reserve decreases the reserve ratio, it lowers the amount of cash that banks are required to hold in reserves, allowing them to make more loans to consumers and businesses.
This increases the nation's money supply and expands the economy. But the increased spending activity can also work to increase inflation.
Now, assume the central bank wants to make its monetary policy somewhat more expansionary, and encourage more lending to spur economic activity.
Board of Governors of the Federal Reserve System. Effective April 24, , money market deposit accounts MMDA , which had previously been subject to full reserve requirements, were made subject to the transitional phase-in program of the Monetary Control Act.
In addition, the order of application of the exemption applied to reservable liabilities was changed. Effective February 2, , Regulation D was amended as follows for institutions reporting weekly on the FR 1 change the reserve computation and maintenance periods from weekly to biweekly, with the former ending on Monday and the latter ending on Wednesday; 2 compute required reserves against net transaction deposits based on average deposits over the computation period ending two days before the end of the maintenance period; 3 compute required reserves against nontransaction deposits based on average deposits over a computation period ending 17 days before the beginning of the maintenance period; and 4 count the average vault cash held during a reserve computation period ending 17 days before the beginning of the reserve maintenance period toward required reserves.
Effective July 24, , the 5 percent marginal reserve requirement on managed liabilities and the 2 percent supplementary reserve requirement against large time deposits were removed. Effective May 29, , the marginal reserve requirement was reduced from 10 percent to 5 percent and the base upon which the marginal reserve requirement was calculated was raised.
Effective March 12, , the 8 percent marginal reserve requirement was raised to 10 percent. In addition, the base upon which the marginal reserve requirement was calculated was reduced. Effective October 11, , a marginal reserve requirement of 8 percent was imposed on "managed liabilities" of member banks, Edge Act corporations, and U. On October 25, required reserves and reserves held by Edge Act Corporations were included in member bank reserves.
Previously reserves held by these institutions were recorded as "other deposits" by Federal Reserve Banks. Effective November 30, , the 10 percent minimum requirement on the domestic deposits of Edges was removed but Edges continued to be subject to the same reserve requirements as member banks. Effective October 30, , the reserve requirement against member bank time deposits with an original maturity of four years or more was reduced from 3 percent to 1 percent.
Effective May 22, , the reserve requirement against foreign borrowings of member banks, primarily Eurodollars, was reduced from 8 percent to 4 percent. In addition, the 3 percent marginal reserve requirement on large certificates of deposit with an initial maturity of less than four months was removed.
Effective December 27, , the marginal reserve requirement against certain time deposits was reduced from 11 percent to 8 percent.
Effective October 4, , the marginal reserve requirement against certain time deposits was increased from 8 percent to 11 percent. Introduction to the Fed. The Fed's Roles and Functions.
Personal Finance Banking. What Are Reserve Requirements? Key Takeaways Reserve requirements are the amount of funds that a bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdrawals. Reserve requirements are a tool used by the central bank to increase or decrease the money supply in the economy and influence interest rates. Article Sources.
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Related Terms Why Bank Reserves Matter Bank reserves are the cash minimums financial institutions must retain to meet central bank requirements. Read how bank reserves impact the economy. Excess Reserves Excess reserves are capital reserves held by a bank or financial institution beyond what is required by law or regulations.
What Is the Federal Funds Rate? The federal funds rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight. The Reserve Ratio Explained The reserve ratio is the portion of reservable liabilities that commercial banks must hold onto, rather than lend out or invest.
This is a requirement determined by the country's central bank, which in the United States is the Federal Reserve. What Is Monetary Policy? Monetary policy is a set of actions available to a nation's central bank to achieve sustainable economic growth by adjusting the money supply.
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