Introduction to Finance

required reserves 
ratio
is the percentage of deposits that must be held as reserves. If a depository institution has 
reserves in excess of the required amount, it may lend them out. This is how institutions earn a 
return, and it is also a way in which the money supply is expanded. In our system of fractional 
reserves, control of the volume of checkable deposits depends primarily on reserve management. 
In Chapter 5 the mechanics of money supply expansion and contraction are explained in detail.
The banking system has 
excess reserves
 
when bank reserves are greater than required 
reserves. The closer to the required minimum the banking system maintains its reserves, the 
tighter the control the Fed has over the money creation process through its other instruments. 
If the banking system has close to the minimum of reserves (that is, if excess reserves are near 
zero), then a reduction of reserves forces the system to tighten credit. If substantial excess 
reserves exist, the pressure of reduced reserves is not felt so strongly. When reserves are added 
to the banking system, depositories may expand their lending but are not forced to do so. How-
ever, since depositories earn low interest rates on reserves, profi t maximizing motivates them 
to lend out excess reserves to the fullest extent consistent with their liquidity requirements. 
When interest rates are high, this motivation is especially strong.
The ability to change reserve requirements is a powerful tool the Fed uses infrequently. 
For a number of reasons, the Fed prefers to use open-market operations to change reserves 
rather than change reserve requirements. If reserve requirements are changed, the maximum 
amount of deposits that can be supported by a given level of reserves changes. It is possible 
to contract total deposits and the money supply by raising reserve requirements while holding 
the dollar amount of reserves constant. Lowering reserve requirements provides the basis for 
expanding money and credit.
It has been argued that “changing reserve requirements” is too powerful a tool and that 
its use as a policy instrument would destabilize the banking system. The institutional arrange-
ments through which the banking system adjusts to changing levels of reserves might not 
respond as effi
ciently to changing reserve requirements. Another advantage of open-market 
operations is that they can be conducted quietly, while changing reserve requirements requires 
a public announcement. The Fed feels that some of its actions would be opposed if public 
attention were directed toward them.