If you were to ask a bank manager how much money is in her bank, she could give you two different answers, and either would be correct. She could tell you how much money her customers have in their accounts, or she could tell you how much of that money the bank actually has on hand. The difference between her answers is the difference between bank deposits and bank reserves.
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"Bank deposits" simply refers to the money that a bank's customers have put in the bank, such as in checking or savings accounts or by buying certificates of deposit. If you took all the customers of a bank and added up the balance of all their deposit accounts, that would give you the bank's total deposits. The Federal Reserve defines deposit accounts as either transaction accounts or non-transaction accounts. The difference between the two boils down to how readily the customer can withdraw money from the account.
If you have a checking account with a $10,000 balance, for example, there isn't a special drawer at the bank with $10,000 in it set aside for you. Banks hold onto only a portion of their deposits, enough to cover typical demand for withdrawals. The rest is available for the bank to lend to other customers. The portion of its deposits that the bank holds onto is called its reserves. It can keep its reserves as cash in its vaults or as deposits with the Federal Reserve bank for its region.
The Federal Reserve sets the minimum amount that a bank must keep in reserve. As of 2011, for example, the Fed requires banks to hold a percentage of their transaction accounts based on a three-step formula. For the first $10.7 million in transaction accounts, there is no reserve requirement at all. For transaction account deposits in excess of $10.7 million but less than $58.8 million, the reserve requirement is 3 percent. For transaction account deposits above $58.8 million, the requirement is 10 percent. So, say a bank has $100 million in transaction accounts. The first $10.7 million is exempt. The next $48.1 million -- that is, from $10.7 million up to $58.8 million -- has a 3 percent reserve requirement, or $1,443,000. The final $41.2 million -- that is, from $58.8 million up to $100 million -- has a 10 percent reserve requirement, or $4,120,000. Add it all up, and the bank must maintain reserves of $5,563,000.
Reserves as Policy Tool
The Fed can use the reserve requirement not only to ensure that banks have enough money available to meet customers' demands for withdrawals, but also to control the money supply. The higher the reserve requirement, the less money banks have available for lending. By locking up deposited money in banks' reserves, the Fed can reduce the amount of money flowing through the economy, which helps tamp down inflation. Conversely, by lowering the reserve requirement, the Fed can encourage lending, which gets more money into the economy to stimulate growth.