Reserve requirement

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The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank.

The reserve ratio is sometimes used as a tool in monetary policy, influencing the country's economy, borrowing, and interest rates [2]. However, Central banks rarely alter the reserve requirements due to the fact that it would cause immediate liquidity problems for banks with low excess reserves. Instead, open market operations are used. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply "M1"), and zero on time deposits and all other deposits.

An institution that holds reserves in excess of the required amount is said to hold excess reserves.

1 Reserve ratios
2 Effects on money supply
3 Reference
4 See also
5 External links
- 5.1 Articles

[edit] Reserve ratios

A cash reserve ratio (or CRR) is the percentage of bank reserves to deposits and notes. The cash reserve ratio is also known as the cash asset ratio or liquidity ratio. The Bank of England holds to a voluntary reserve ratio system. In 1998 the average cash reserve ratio across the entire United Kingdom banking system was 3.1%. Other countries have required reserve ratios (or RRRs) that are statutorily enforced (sourced from Monetary Macroeconomics by Dr. Pinar Yesin ^[1] ):

Country	Required Reserve Ratio %
Australia	None
Canada	None
Mexico	None
Sweden	None
United Kingdom	None
Eurozone	2.00
Slovakia	2.00
Switzerland	2.50
Chile	4.50
India	6.50
Bulgaria	8.00
Latvia	8.00
Burundi	8.50
Hungary	8.75
China	10.50
Pakistan	7.00
Ghana	9.00
United States	10.00
Estonia	15.00
Zambia	17.50
Croatia	19.00
Tajikistan	20.00
Suriname	35.00
Jordan	80.00

In some countries, the cash reserve ratios have decreased over time (sourced from IMF Financial Statistic Yearbook):

Country	1968	1978	1988	1998
United Kingdom	20.5	15.9	5.0	3.1
Turkey	58.3	62.7	30.8	18.0
Germany	19.0	19.3	17.2	11.9
United States	12.3	10.1	8.5	10.3

[edit] Effects on money supply

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit can lend up to $90 of that deposit, keeping only $10 of deposits in the bank. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As this fractional-reserve banking process continues, the banks can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

Supply-side economics, however, suggests that at least in the long run, the supply curve is nearly vertical. Thus, an increase in demand leads only to inflation. Supply-siders believe that the Federal Reserve is impotent in regards to business cycles.^[2]

Even if the supply curve is relatively horizontal, the connection between reserve requirements and money supply is not nearly as strong in practice as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits such as CDs, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.