Introduction to Finance

fractional reserve system 
reserves 
must be held equal to a certain 
percentage of bank deposits
bank reserves 
vault cash and 
deposits held at Federal Reserve 
Banks
required reserves 
the minimum 
amount of total reserves that a 
depository institution must hold
required reserves ratio 
percentage 
of deposits that must be held as 
reserves
excess reserves 
the amount by 
which total reserves are greater 
than required reserves

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C H A PT E R 4 Federal Reserve System
Changing reserve requirements has been used as a policy instrument on occasion. In the 
late 1930s, the nation’s banks were in an overly liquid position because of excessive reserves. 
Banks had large amounts of loanable funds that businesses did not wish, or could not qualify, 
to borrow because of the continuing depression. The reserves were so huge that the Fed could 
no longer resolve the situation through its other policy instruments. Therefore, it increased 
reserve requirements substantially to absorb excess reserves in the banking system.
Reserve requirements were lowered during World War II in order to ensure adequate credit 
to fi nance the war eff ort. But they were raised again in the postwar period to absorb excess 
reserves. In the 1950s and early 1960s, reserve requirements were lowered on several occasions 
during recessions. In each case, the lowering made available excess reserves to encourage bank 
lending, ease credit, and stimulate the economy. By using this policy tool, the Fed was publicly 
announcing its intention to ease credit, in hopes of instilling confi dence in the economy.
In the late 1960s and 1970s, reserve requirements were selectively altered to restrain 
credit, because the banking system was experimenting with new ways to get around Fed con-
trols. Banks were using more-negotiable certifi cates of deposit, Eurodollar borrowings, and 
other sources of reserve funds. This prompted the Fed to impose restraint on the banks by 
manipulating the reserve requirements on specifi c liabilities.
The evolution of the banking system eventually led Congress to pass the 
Depository Insti-
tutions Deregulation and Monetary Control Act (DIDMCA) of 1980
, which made signifi cant 
changes in reserve requirements throughout the fi nancial system. Up to this time the Fed 
had control over the reserve requirements of its members only. Nonmember banks were sub-
ject to reserve requirements established by their own states, and there was considerable vari-
ation among states. As checks written on member banks were deposited in nonmember banks 
and vice versa, funds moved among banks whose deposits were subject to diff erent reserve 
requirements. This reduced the Fed’s control over the money supply.
The 1980 act applies uniform reserve requirements to all banks with certain types of 
accounts. For banks that were members of the Fed, these requirements are, in general, lower 
now than they were prior to the act. In general, for approximately the fi rst $50 million of 
transaction account deposits at a depository institution, the reserve requirement is 3 percent. 
For deposits over approximately $50 million, the reserve requirement is 10 percent, which 
was reduced from 12 percent in April 1992. The “break point” between the 3 percent and the 
10 percent rates is subject to change each year based on the percentage change in transaction 
accounts held by all depository institutions. In general, transaction accounts include deposits 
against which the account holder is permitted to make withdrawals to make payments to third 
parties or others. Accounts that restrict the amount of withdrawals per month are considered 
to be savings accounts rather than transaction accounts.
Banks and other depository institutions with large transaction account balances, thus, 
are required to hold a proportionately higher percentage of reserves. Let’s illustrate this point 
under the assumption that the reserve requirement will be 3 percent on the fi rst $50 million of 
transaction account balances and 10 percent on amounts over $50 million. Assume that First 
Bank has $50 million in transaction accounts while Second Bank has $100 million. What are 
the dollar amounts of required reserves for each bank? What percentage of required reserves 
to total transaction deposits must be held by each bank? Following are the calculations: