Question

Why does the Federal Reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is the significance of excess reserves?

Answer 1

Ans

Reserve requirements are the amount of cash that the bank holds. The Federal Reserve require commercial banks to have reserves so that the reserve bank can regulate the money supply in the economy and also influence the interest rates. The Federal Reserve bank uses the reserve requirements as a monetary tool as by increasing the reserve requirements it excercises the contractionary monetary policy as it decreases the liquidity and cools down the economy whereas by decreasing the reserve requirements it excercises the expansionary monetary policy as it increases the liquidity.

Reserves are considered as an asset to the commercial banks since these funds are in the cash form belonging to the commercial banks and they can claim it against the Federal Reserve Bank. As bank reserves are divided into reserves and excess reserves.These reserves can be utilised by the commercial banks in order to meet the uncertain liability such as sudden withdrawals.

Excess reserves are the funds held by the commercial banks that exceed the minimum requirements of the Federal Reserve Bank. Excess reserves are also known as secondary reserves. In order to encourage the excess reserve the Federal Banks pays the interest on these excess reserves.

Excess reserves can be calculated by subtracting required reserves from actual reserves.

Excess Reserves = Actual Reserve - Required Reserve

Below mentioned are the significance of excess reserves:

1. Excess reserves facilitates to meet the fund requirements of upcoming transactions or in clearing some contractual clearing balance requirements.

2. The federal bank pays interest on these ecxcess reserve with the aim to encourage bank behaviour that supports the Federal Reserve's targets.

3. Excess reserves increases the safety of the banks during the economic uncertainities.