Reserves are the funds held by a depository institution --
either kept on deposit in their account at the Federal
Reserve Bank in their District or as vault (or ATM) cash.
Reserves are used by banks to meet their legal reserve
requirement (currently about 10% of their transaction
deposits), which is set by the Fed.
Before the Federal Reserve was created, the requirement
that a bank hold a portion of its deposits in reserve
was thought to help ensure the liquidity of bank notes
and deposits, especially during times of financial strain.
Since the establishment of the Fed as the lender of last
resort, the notion that required reserves would serve as
a source of liquidity largely faded away. Instead, by
helping ensure a stable demand for reserves within the
financial system, reserve requirements have played an
important role in supporting the Fed’s ability to conduct
open market operations.
Beyond their required reserves, banks’ excess reserves can
be used to make loans, buy securities…or, they can simply
stay put in their Reserve Bank account and earn interest
from the Fed.
Interest on excess reserves -- a key inflation fighting
tool. Reserves held at the Fed have reached historic levels
from less than $50 billion until late 2008). But, these
reserves won’t necessarily lead to new lending -- and,
that’s largely due to the Fed’s ability to pay interest
on excess reserves (a power granted to the Fed by Congress
in 2008). By raising the interest rate it pays on reserves,
the Fed can discourage excessive growth in money or credit
by encouraging banks to keep their money at the Fed, rather
than lending it out.
Sheila McKinney
