The reserve ratio is the portion of depositors’ balances that banks must have on hand as cash. This is a requirement determined by the country’s central bank, which in the United States is the Federal Reserve. The reserve ratio affects the money supply in a country at any given time.
Governments often use reserve requirements as a control over the money supply. The basic money supply of most countries is made up of cash plus the total of all bank demand deposits. The reserve ratio creates a multiplier effect on the cash. When a person deposits 1,000 in the bank, the bank is not required to keep all of that 1,000 on hand in case the depositor wants it back later – the bank is only required to keep a portion on hand. The percentage of cash the bank is required to keep (and thus not lend out) is the reserve ratio.
Assume ABC Bank has total deposits of 2 billion and the reserve ratio is 12%. This means that ABC is required to keep 240 million in cash reserves. In most developed countries, the majority of the cash reserve is kept at the central, governing bank, and a fraction is in the bank’s own vaults. The cash is transferred between the two based on daily cash needs.
In the United States, the Federal Reserve controls the reserve ratio requirements. Currently, banks with deposits of less than 14.5 million have zero reserve requirements. For banks with deposits between 14.5 million and 103.6 million, the reserve requirement is 3%. It’s 10% for banks with deposits exceeding 103.6 million.
Purpose and Functions (1994) describes how a change in the reserve requirement ratio affects bank credit and the money stock.Reserve requirements are the percentage of deposits that depository institutions must hold in reserve and not lend out. For example, with a 10 percent reserve requirement on net transaction accounts, a bank that experiences a net increase of 200 million in these deposits would be required to increase its required reserves by 20 million. The bank would be able to lend the remaining 180 million of deposits, resulting in an increase in bank credit. As those funds are lent, they create additional deposits in the banking system. 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.
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.
The volume of net transaction deposits held by all depository institutions is large, 566.5 billion, as of June 2001 (see table and H.6 Release). Thus, even a small change in the reserve requirement ratio may have a relatively large effect on reserve requirements and the money stock.