Question

What determines the demand for reserves by banks? The supply? How do open market operations affect the supply of reserves? A change in the discount rate?

Answer 1

The banks need reserves mainly for two purposes: one is for the regulatory purposes which are the minimum requirement which the central bank asks the banks to keep as a part of monetary policy. Second is for the precautionary purposes. This is to meet the demand of the consumers for their checkable deposits as when they come to the banks to withdraw their amounts, they should be provided with the same.

The supply or the growth of the banks' reserves is managed by the central bank or FED for the stable expansion of the economy. The various methods used by the FED are changing the reserve requirements, change in discount rates and open market operations.

Under the open market operations, the Fed buy or sell the government securities. When the Fed buys the securities, it increases the money supply in the economy while by selling off the securities, the money supply got reduced as the money moves from the economy to back to the central bank.

Under the discount rate policy, the central bank changes the rate at which it lends the banks for the additional reserves. By decreasing the discount rate, the central bank tempts the banks to borrow more thus increase their reserves.