Question

Discuss the various types of reserves used in the U.S. banking and by the Fed. (Ch. 15)

Answer 1

The various types of reserves used in the US banking system and by the Federal Reserve are as follows -

1. Legal Reserves - This is the total amount of vault cash and federal reserve deposits. Vault cash are paper bills that are kept with the banks to satisfy the customer withdrawal demand. Further, federal reserve deposits are the deposits that commercial banks keep with the federal reserve system.

2. Required Reserves - This is the amount of reserve that is required to be held by commercial banks as a percentage of total deposits in the bank or banking system. The required reserve can be altered to increase or reduce the money supply in the banking system. Just as an example, when the required reserve is increased, banks have to hold more cash as reserves and this reduces the money supply. Similarly, when the economy is in a slowdown, the central bank can reduce reserve requirement to increase the money supply and lower interest rates.

3. Excess Reserves - These are reserves that are held by the commercial banks over the level of required reserves. The reason can be that the banks are averse to lending in a weak economic scenario and they hold excess reserves instead of lending. The excess reserves deposited with the fed can earn interest and during the financial crisis of 2008-09, excess reserve of depository institutions surged with banks unwilling to lend.