Question

Discuss the reserve requirements method of conducting monetary policy, including a description of this method, the types of adjustments banks are likely to be required to make and the effects on the economy that are likely to result.

Answer 1

A method of conducting monetary policy is for the central bank to increase or lower the reserve requirement which, as we noted earlier, is the percentage of deposits made by each bank that it is legally required to keep either as cash in its vault or on deposit with the central bank. If banks have to keep a larger sum of deposits, they have less capital to lend out. If banks are permitted to keep a smaller sum of reserves, they'll have more money to lend out.

The Federal Reserve in early 2015 required banks to maintain reserves equal to 0 per cent of the first $14.5 million in deposits, then maintain reserves equal to 3 per cent of deposits up to $103.6 million, and 10 per cent of any sum above $103.6 million. Minor improvements are made to the reserve criteria almost quarterly. For example, the dividing line of $103.6 million is sometimes bumped up or down by a few million dollars. Significant adjustments in reserve ratios are seldom used in practice to enforce monetary policy. A sudden demand for all banks to raise their reserves would be highly disruptive and difficult to satisfy, thus loosening too much criteria would pose a danger that banks would not be able to meet the demand for withdrawals.

If the bank isn't getting enough to reach its goal, it borrows from other banks. This can also borrow from the Discount window of the Federal Reserve. The money banks borrow or lend to each other to meet the reserve requirement is referred to as federal funds. The interest which they charge each other on borrowing fed funds is the cost of fed funds. This rate is the basis of all other interest rates.

The Federal Reserve can not require banks to stick to their target limit. Rather it affects the prices of banks through their open market operations. The Fed purchases securities from member banks — usually Treasury bills — when it requires the fed funds rate to fall. The Fed adds credit in return for protection, to the bank's account. Since the bank needs this extra fund to work, it's going to try to lend it to other banks. For this to happen, banks cut their interest rates.