A legally required reserve ratio is one of the important central bank instruments for changing the stock of money in circulation. The reserve ratio is the fraction of customer deposits banks hold in the form of assets that satisfy a legal definition of reserves. In the United States only vault cash or deposits at a Federal Reserve Bank may legally serve as reserves. A reduction in the legally required reserve ratio, allowing banks to loan out more depositor funds, leads to an expansion of the money stock. Raising this ratio reduces the money stock.
Commercial banks accept deposits of funds from customers. On a given day the fresh deposits approximately offset withdrawals from earlier deposits, leaving the bank with an average level of deposits available for loans to customers. Banks keep a fraction of these deposits as reserves to keep the bank solvent during those intervals when fresh deposits fall short of withdrawals. Without government regulation of reserve requirements, banks often fall prey to the temptation to trim reserves too thinly and come up short of funds if depositors suddenly place heavy demands for cash withdrawals. Because reserves are funds that are not invested, and therefore not earning income, banks have an incentive to hold reserves to a minimal level.
In the United States the Banking Act of 1935 authorized the Board of Governors of the Federal Reserve System to vary the legally required reserve ratio within prescribed limits. Before the Act of 1935 legal reserve ratios were set by statute. From 1935 until 1980 the Board of Governors could change the reserve requirements of commercial banks that were members of the Federal Reserve System, which included all commercial banks with national charters. State banks remained subject to state statutory reserve requirements until 1980. The Depository Institution Deregulation and Monetary Control Act of 1980 gave the Board of Governors authority to set reserve requirements for all depository institutions. The legal reserve ratio is usually set well below 20 percent. In 1992 the Board of Governors reduced the ratio from 12 to 10 percent.
If the level of deposits in a bank rises by $1,000, and the legal reserve ratio is 10 percent, the bank has to retain only $100 as reserves and can loan out the other $900. If the reserve ratio is cut for all banks, each bank can immediately loan out more funds.
Furthermore, as deposits at each bank grow from the lending at other banks, each bank can loan out a share of new deposits. The cumulative effect of these actions on the ratio of customer deposits to vault cash and deposits at the Federal Reserve Banks can be dramatic. If the legal reserve ratio decreased from 20 percent to 10 percent, the ratio of customer deposits to vault cash and deposits at the Federal Reserve Banks could double. Because bank deposits account for the lion’s share of money supply measures, a reduction in the legal reserve ratio can sharply increase the money stock. An increase in the legal reserve ratio can have an equally blunt impact on the money stock in the opposite direction.
Significant controversy arose out of one of the early policy actions using legal reserves requirements. In 1936 commercial banks were flush with reserves, representing a potential for substantial increase in lending and monetary growth. The United States economy was still inching out of the depression, but the banking system brimming over with reserves aroused inflationary fears. The Board of Governors virtually doubled reserve requirements to mop up excess reserves. In 1937 the recovery stalled out, nosing the economy over into another recession, and many observers put the blame at the feet of the improper use of legal reserve requirements by the Board of Governors.
Today legal reserve ratios are one of the less important means of regulating monetary growth. Small changes in legal reserve ratios have powerful effects and create management difficulties for banks. Open market operations have become the most important means of regulating the money stock in the United States. Open market operations have to do with central bank purchases and sale of government bonds. When a central bank purchases bonds with new funds, the money stock increases.