Reserve Requirement

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Definition of Reserve Requirement:

The reserve requirement is the minimum percentage of deposits a bank or thrift must hold in its vaults or on deposit with the Federal Reserve Bank in its district. This money cannot be loaned or invested.

Detailed Explanation:

The reserve requirement is one of the tools a central bank uses to manage a nation's money supply under a fractional reserve banking system. Deposits exceeding the reserve requirement are excess reserves, which can be loaned. When a central bank raises its reserve requirement it reduces the amount a regulated bank has in excess reserves, which means the bank is able to lend less money to its customers.

For example, assume First Community Bank holds $1.0 million in customer deposits. The central bank sets the reserve requirement at ten percent. First Community would be required to maintain minimum balance of $100,000 (ten percent) in its vaults or on deposit with the central bank. It is permitted to lend the remaining $900,000, which are its excess reserves. Assume the central bank increases its reserve requirement to 15 percent. First Community would be required to increase its reserve deposits to $150,000 and reduce its lending to $850,000. Because the reserve requirement affects the amount of money banks are permitted to lend, it has also affects the growth in the money supply, or money multiplier. The money multiplier estimates the amount the money supply increases following an increase in reserves. The reserve requirement has an indirect relationship with the money multiplier. The above example illustrates that banks have more money to lend if less money is kept in reserves. The maximum increase or monetary multiplier can be calculated using the formula below where, MM is the monetary multiplier and RR is the reserve requirement.

MM = 1 / RR

If the above formula is used we can determine that a deposit of $1,000 could increase the money supply $6,667.

MM = 1 / .15
MM = 6.667
$1,000 x 6.667 = $6,667

Realistically, not all the of the cash loaned out is redeposited, and banks do not lend all of their excess reserves. Money that is not redeposited cannot contribute to the expansion of the money supply. Leakage occurs when borrowers hold currency or when banks hold excess reserves. The US Reserve requirement is ten percent, yet because of leakage the Federal Reserve Band of St. Louis estimates the M1 multiplier is closer to one! Open the link to FRED for the current M1 multiplier and historical graph. The revised formula for the multiplier with leakage equals. LR is the leakage ratio.
MM = (1+ LR)
(RR + LR)

The Fed does not change the reserve requirement frequently. The present reserve requirement (March 6, 2017) is approximately ten percent. Increasing the reserve requirement slows the money supply's growth because less money is available to lend. Reducing the reserve requirement expands the money supply by encouraging banks to lend more. 

Dig Deeper With These Free Lessons:

Monetary Policy - The Power of an Interest Rate 
What is Money
Fractional Reserve Banking and The Creation of Money

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