Changes in Reserve Requirements

In principle, the Federal Reserve has a third monetary policy tool at its disposal: it has the power to change, within statutory limits, the reserve-requirement ratio. This ratio specifies the amount of reserves that depository institutions must have for each dollar of deposits. Changes in the ratio alter the dollar amount of reserves that depository institutions must hold against their deposits; in other words, they affect their demand for reserves.

Changes in the demand for reserves can have the same effects as reducing the supply of reserves. A reduction in reserve requirements, for example, would mean that institutions would find that their existing reserves holdings are in excess of what they are required to hold under new, lower requirements.

Reducing reserve requirement therefore is equivalent to increasing the supply of reserves: it starts the process of multiple expansion of loans and deposits described earlier, and the process continues until the excess reserves have disappeared. By the same token, an increase in reserve requirements is equivalent to a reduction in reserve supply, causing a multiple contraction in deposits outstanding.

In current practice, changes in reserve requirements are seldom used to control money. They are considered too "blunt" an instrument in the sense that relatively small changes in requirements can produce large increases or decreases in money. Moreover, changes in reserve requirements can affect the profitability of depository institutions since they change the ratio of non-earning assets (reserves) to deposits in these institutions.

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