Interest Rate Determination

When the Fed lowers the reserve requirement on deposits, the money supply increases. When the Fed raises the reserve requirement on deposits, the money supply decreases.

The reserve requirement is a rule set by the Fed that must be satisfied by all depository institutions, including commercial banks, savings banks, thrift institutions, and credit unions. The rule requires that a fraction of the bank's total transactions deposits (e.g., this would include checking accounts but not certificates of deposit) be held as a reserve either in the form of coin and currency in its vault or as a deposit (reserve) held at the Fed. The current reserve requirement in the United States (as of December 2009) is 10 percent for deposits over $55.2 million. (For smaller banks - that is, those with lower total deposits - the reserve requirement is lower).

As discussed above, the reserve requirement affects the ability of the banking system to create additional demand deposits through the money creation process. For example, with a reserve requirement of 10 percent, Bank A, which receives a deposit of $100, will be allowed to lend out $90 of that deposit, holding back $10 as a reserve. The $90 loan will result in the creation of a $90 demand deposit in the name of the borrower, and since this is a part of the money supply M1, it rises accordingly. When the borrower spends the $90, a check will be drawn on Bank A's deposits and this $90 will be transferred to another checking account, say, in Bank B. Since Bank B's deposits have now risen by $90, it will be allowed to lend out $81 tomorrow, holding back $9 (10 percent) as a reserve. This $81 will make its way to another bank, leading to another increase in deposits, allowing another increase in loans, and so on. The total amount of demand deposits (DD) created through this process is given by the formula

$DD = \text{\$100 + (.9)\$100 + (.9)(.9)\$100 + (.9)(.9)(.9)\$100 +….}$

This simplifies to

$DD = \text{\$100/(1 − 0.9) = \$1,000}$

or

$DD = \text{\$100/RR, }$

where $RR$ refers to the reserve requirement.

This example shows that if the reserve requirement is 10 percent, the Fed could increase the money supply by $1,000 by purchasing a $100 Treasury bill (T-bill) in the open market. However, if the reserve requirement were 5 percent, a $100 T-bill purchase would lead to a $2,000 increase in the money supply.

However, the reserve requirement not only affects the Fed's ability to create new money but also allows the banking system to create more demand deposits (hence more money) out of the total deposits it now has. Thus if the Fed were to lower the reserve requirement to 5 percent, the banking system would be able to increase the volume of its loans considerably and it would lead to a substantial increase in the money supply.

Because small changes in the reserve requirement can have substantial effects on the money supply, the Fed does not use reserve requirement changes as a primary lever to adjust the money supply.