Posted: March 30th, 2022
Issue4: Excess reserves and Reserve Requirements
How the Federal Reserve employs the monetary policy tool of Excess reserves and reserve requirement by the banks to control the
Reserve requirements are the number of funds that a bank holds in reserve to ensure that it can meet liabilities in case of sudden withdrawals. Reserve requirements are a tool used by the central bank to increase or decrease the money supply in the economy and influence interest rates. By reducing the reserve requirement, the Fed is executing an expansionary monetary policy, and conversely, when it raises the requirement
, it is exercising a contractionary monetary policy. This action cuts liquidity and causes a cool down in the economy.
Similarly, the Excess reserves are capital reserves held by a bank or financial institution more than what is required by regulators, creditors or internal controls. Financial firms that carry excess reserves have an extra measure of safety in sudden loan loss or significant cash withdrawals by customers. The interest rate on excess reserves is now being used in coordination with the Fed funds rate to encourage bank behaviour that supports the Federal Reserve’s targets. Historically, the fed funds rate is when banks lend money to one another and are often used as a benchmark for variable rate loans. The Fed has been using the interest on excess reserves to create a band between the Fed funds rate and the IOER by setting it purposely below to keep their target rates on track.”
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