Reserve Requirements
Categories: Banking
The reserve requirement tells banks what percent of the money that is deposited must be kept in a sort of rainy day fund.
High reserve requirements keep banks safer, since if people rush banks demanding their money back, like the bank panic in 1929 preceding the Great Depression, banks will at least be able to pay back some of it immediately. The downside to a high reserve requirement is that it lowers the money multiplier, which makes it harder to get loans and reduces the overall money supply. This deters investment and slows long-term economic growth.
Example:
An alien from Mars shows up at a bank carrying a case full of $100,000 of freshly minted dollar bills. Since the alien is bringing his cash from somewhere other than Earth, the cash has not yet been accounted for in the money supply. By initally injecting this additional 100 grand into the money supply through the banks, what's the total effect on the money supply? Well, the money multiplier effect depends on the reserve requirement.
In the US, the Fed, a.k.a. the Federal Reserve, a.k.a. the central bank, keeps a watchful eye on Reserve Banks, who keep a watchful eye on commercial banks. Yep, it’s a hierarchy. If the Fed is like a royal family, then Reserve Banks are dukes and duchesses, and the commercial banks are aristocrats.
The Fed requires banks to meet “reserve requirements,” also known as the “cash reserve ratio,” which is the amount of money banks have to keep on hand. Why is this a rule? Well, part of what spawned the Fed into existence was a series of runs on banks from banking panics. A “run on a bank” is when everyone rushes to their bank and demands all of their deposits back. The thing is that one of the ways banks make money is by...lending out money. Yep, your money. Your deposits. For banks to make the most money possible, they would lend out as much money as they could...which, in theory would be all of it. But that leaves you, the depositor, without cash when you need it. The Fed wanted runs on banks to be a thing of the past (which they pretty much are now), so they established reserve requirements.
The money that banks are allowed to loan out are called “excess reserves.” For instance, a bank may be required to have 10% of its total money on hand, which would mean the remaining 90% of the money is excess reserves, which banks can lend out to turn a profit.
Now...here’s where the magic happens: multiple expansion of deposits. Multiple expansion of deposits is the theory that each deposit into a bank creates additional money made from excess reserve deposits as they are continuously lent out by, and re-deposited in, banks. There’s a literal multiplier effect that ripples outward into the economy called the “deposit expansion multiplier,” which estimates the maximum amount of money the Fed could expect a deposit injection into the economic system to create. This is how the Fed decides how much new money to pump into the economy, and the maximum effect they could possibly expect from that injection of money.
For instance, let’s say your bank has a 10% reserve requirement, leaving 90% in excess reserves. When that money is lent out, it’s deposited into another bank...eventually. So...let’s say you deposit a $2,000 check into your bank account. Your bank says “whoopee!” and lends out 90% of it, which is $1,800 (that other $200 they’re going to keep on hand for reserve requirements). Say that $1,800 is lent out to Climber Chris, who’s keen on climbing Everest. Climber Chris deposits that $1,800 into his bank account. Climber Chris’s bank says “whoopee!” just like your bank, and does the same thing: the bank lends out 90% of the $1,800, which is $1,620. The remaining 10% ($180) is kept at Climber Chris’s bank to meet reserve requirements. Climber Chris’s bank lends out $1,620 to Teacher Tina, who’s running short on school supplies and gas. Teacher Tina puts that $1,620 into her bank account. You can guess what Teacher Tina’s bank does. Yep, same as your bank, and same as Climber Chris’s bank, Teacher Tina’s bank lends out 90% of the money she deposited, which is $1,448, to Dan the Man...and so on and so on.
In this way, an initial deposit actually grows, providing more value than the initial amount deposited. Each time money is loaned out and redeposited, only 90% of that deposit gets turned into a new loan. We can keep taking 90% of the deposits (the maximum amount banks could loan out from that deposit) until the amount loaned out and deposited gets to pennies. You still have that $2,000 in your bank account that belongs to you. Meanwhile, Climber Chris has $1,800 that he can spend, and Teacher Tina has $1,620 that she can spend, which all came from your initial deposit.
How can $2,000 that was in your bank account multiply into additional value that other people can use in the economy? We told you that multiple expansions of deposits was magic. It literally expands the money supply. Remember that deposit expansion multiplier we mentioned earlier? It’s how the Fed can measure the maximum amount of money an initial injection of a deposit can be expected to create.
The deposit expansion multiplier is 1 divided by the reserve requirement. In our case, that’s 1 / 0.10...or 10. We can use the deposit expansion multiplier to see how much money your $2,000 deposit expanded the money supply. To figure out how much a deposit expanded the money supply, we multiply the expansion multiplier by the initial excess reserves. In our scenario, the reserve requirement is 10%, which gives us the deposit expansion multiplier of 10. Then we take the excess reserves from the initial deposit (you know, the 90% chunk of money that was created into the first loan for Climber Chis by your bank), which was $1,800. $1,800 x 10 = $18,000. 90% of your deposit was loaned out and deposited (to Climber Chris), then 90% of that was loaned out and deposited (to Teacher Tina), and 90% of that was loaned out and deposited (to Dan the Man), etc. If we assume the banks loaned out 90% at each stage, then it means the money supply was expanded by $18,000.
Yep. That means (assuming a reserve requirement of 10% for all commercial banks) that your initial deposit of $2,000 expanded the money supply by $18,000 in the economy. Yes, you can tell everyone “You’re welcome” now.
Okay...besides feeling like a money expansion superhero, why we care about multiple expansion of deposits? The Fed is in charge of keeping the economy healthy. One major way of doing that is by maintaining the money supply. You can think about the Fed as a doctor and the economy as a patient, with the money supply as blood pressure. A low blood pressure (a low money supply) means multiple expansion of deposits is low. Which means there’s less money flowing through the economy, which results in less spending, and slower economic growth. No like-y.
Blood pressure that’s too high (a high money supply) isn’t good either though. We’ve seen it before in history where a government just starts printing more and more money without the corresponding economic growth. What happens? Hyperinflation: prices of everything skyrocket, and money becomes almost useless...which is not good for the economy. That $2 milk? Now it’s $100. A month later, it’s $6,000. That’s not even an exaggeration…some places have faced hyperinflation of 3,000%.
The Fed’s job is to keep the economy’s money supply stable, which means it needs to be not too high, and not too low. When the Fed raises interest rates, it lowers the demand for loans, which lowers the amount of excess reserves loaned out, and slows the growth of the money supply from slower expansions of deposits. When the Fed lowers interest rates, it’s trying to increase demand for loans, encouraging the multiple expansion of deposits to grow the money supply.
Besides interest rates, the Fed can tinker with things like "stimulus packages" and other strategies to expand (or contract) the money supply. So now you know: money doesn’t grow on trees…but it does grow out of your bank account.
Related or Semi-related Video
Econ: What are Reserve Requirements, Exc...19 Views
And finance Allah shmoop What our reserve requirements excess reserves
and the multiple expansion of deposits in the US The
Fed a k a The Federal Reserve a k a
The central bank keeps a watchful eye on reserve banks
who keep a watchful eye on commercial banks So yes
there's a whole hierarchy If the Fed is like a
royal family well then reserve banks or dukes and duchesses
and the commercial banks are aristocrats The Fed requires banks
to meet reserve requirements also known as the cash reserve
ratio which is the amount of money banks have to
keep on hand Handy Dandy Ready for quick withdrawal Why
is this a rule Well part of what spawned the
Fed into existence in the first place was a siri's
of runs on banks from banking panics A run on
the bank is when everyone rushes to their bank and
demands all of their deposits back Now the thing is
one of the boys banks make money is by lending
out your money to other people Yep your money Your
deposit for banks to make the most money possible Well
they would lend out as much money as they could
which in theory would be all of it But then
that leaves you the deposit or without cash when you
need it The Fed wanted runs on banks to be
a thing of the past which they pretty much are
now so they made these reserve requirements The money that
banks are allowed to loan out are called the excess
reserve For instance a bank may be required to have
say ten percent of its total money on hand which
would mean the remaining ninety per cent of the money
is excess reserves which banks can lend out to turn
a profit Now here's where the magic happens Multiple expansion
of deposit Well multiple expansion of deposits is the theory
that each deposit into a bank creates additional money made
from excess reserve deposit as they are well continuously lent
out by banks and then re deposited in other banks
There's a literal multiplier effect that ripples outward into the
economy called the Deposit Expansion Multi a buyer which estimates
the maximum amount of money that the Fed could expect
in deposit injection into the economic system that you know
they were kind of creating and managing Well this is
how the Fed the controller of the money supply decides
how much new money toe pump into the economy and
the maximum effect they could possibly expect from that injection
of money into the system For instance let's say your
bank has a ten percent reserve requirement leaving ninety percent
in excess reserves Well when that money is lent out
whether to a consumer or a business it's deposited into
another bank eventually So let's say you deposited two thousand
dollars check into your bank account in your bank says
would be and it lends out ninety percent of it
which is eighteen hundred box right that other two hundred
dollars they were going to keep on hand for reserve
requirements Okay so let's say that eighteen hundred dollars is
linked to a climber Chris who's keen on climbing Mount
Everest climber Chris deposits that eighteen hundred dollars into his
bank account Clymer Chris's bank says would be just like
your bank and they do the same thing that bank
lens Ninety percent of the eighteen hundred dollars which is
sixteen hundred twenty bucks The remaining ten percent that hundred
eighty is kept at Climber Chris's Bank to meet reserve
requirements Well Climate Chris Bank then lends out six hundred
twenty dollars to teacher Tina who's running short on school
supplies and gas Teacher Tina What's that Sixteen twenty into
her bank account And you can guess what teacher Tina's
bank account does Yep same is your bank and same
as Climber Chris's bank and teacher Tina's bank lends out
ninety percent of the money she deposit which is a
fourteen hundred forty eight dollars to Dan the Man and
so on Under this system and initial deposit actually grows
providing more value than the initial amount deposited Its multiplied
each time money is loaned out and then re deposited
only ninety percent That deposit gets turned into a new
loan Well we could keep taking ninety percent of the
deposits The maximum amount thanks can loan out from that
deposit until the amount loaned out deposited gets just any
words No more counting anymore So you still have that
two thousand dollars in your bank account that belongs to
you Meanwhile climate Chris has eighteen hundred and you can
spend a teacher Tina has sixteen twenty that she can
spend and it all came from your initial deposit Thank
you very much Well how Khun to Grand that was
in your bank account multiply into additional value that other
people can use in the economy But we told you
that multiple expansions of deposits was magic It literally expands
the money supply Will remember that deposit expansion multiplier we
mentioned earlier It's how the Fed can measure the maximum
amount of money and initial injection of a deposit like
your two grand can be expected to create Will the
deposit expansion multipliers just calculated as one divided by the
reserve requirements sonar case That's one By the by point
one or ten we can use the deposit expansion multiplier
to see how much money you're too grand Deposit expanded
the money supply under this setting to figure out how
much a deposit expanding the money supply We just multiply
the expansion multiplier by the initial excess reserves On our
scenario the reserve requirements ten percent which gives a deposit
expansion multiplier of ten Then we take that excess reserves
from the initial deposit You know that ninety percent chunk
of money that was created into the first loan for
climate Chris by your bank and I was eighteen hundred
bucks right So you're going to multiply that eighteen hundred
by ten So ninety percent ofyour deposit was loaned out
on deposit to Climate Chris and I sounded out blown
out positive Tina and I pretended I was loaned out
and positive Dan the Man and so on So if
we assume the bank's loaned out ninety percent of stage
while then it means the money supply was expanded by
eighteen thousand dollars That means assuming a reserve requirement of
ten percent for all commercial banks while your initial deposit
of two grand expanded the money supply nine times to
be eighteen thousand dollars in the economy Yes you Khun
tell everyone you're welcome Okay So besides feeling likea money
expansion superhero why do we care about multiple expansion of
deposits Well the Fed is in charge of keeping the
economy healthy One major way of doing that is by
maintaining the money supply you can think about That is
a doctor and the economy is a patient with the
money Supply is well the blood pressure A low blood
pressure like a low money supply means multiple expansion of
deposit is low which means there's less money flowing through
the economy which results in less spending and slower economic
growth Yeah no likey Blood pressure that's too high like
a high money supply isn't good either though we've seen
it before in history where a government just starts printing
more and more money without the corresponding economic growth and
what happens well hyperinflation prices of everything skyrocket and money
becomes almost useless People lose trust in the system And
oh that's so not good for the economy So that
two dollar milk and now it's one hundred dollars a
carton a month later Six thousand Some places have faced
hyperinflation of like three thousand percent a year or more
Well the feds jobs to keep the economy's money supply
like blood pressure stable which means it needs to be
not too high not too low Well when the Fed
raises interest rates it essentially lowers the demand for loans
It lowers the amount of access reserve loaned out and
that whole process slows the growth of the money supply
from slower expansions of deposits When the Fed lowers interest
rates it's trying to increase demand for loans encouraging the
multiple expansion of deposits to grow the money supply well
Besides interest rates the Fed can tinker with things like
stimulus packages and other strategies to expand or contract the
money supply They do all kinds of things They're sort
of crazy All right so now you know money does
not grow on trees but well it does grow out
of your bank account So let's go deposits him though