Question

What are "required reserves"? What are "actual reserves" and "excess reserves"?

Short answer

Required reserves are the minimum amount of cash a bank must hold by law or regulations, usually set by central banks. Actual reserves are the total cash and cash-equivalent assets a bank has at any given time. Excess reserves are the difference between a bank's actual and required reserves, representing the available funds for lending, investing, or meeting other obligations.

Step-by-step solution

Required Reserves

Required reserves are the minimum amount of cash that a bank is required to hold by law or regulations to ensure that it has enough funds to pay customers in case of withdrawals. Central banks, like the Federal Reserve in the United States, set the required reserve ratio depending on the total amount of deposits at the bank. The required reserve ratio is expressed as a percentage of the total deposits, and it represents the portion of deposits that cannot be loaned out by the bank. For example, if a bank has \(100,000 in total deposits and the required reserve ratio is 10%, the required reserves would be \)10,000, and the bank could loan out the remaining $90,000 to borrowers.

Actual Reserves

Actual reserves are the total amount of cash and cash-equivalent assets that a bank holds at any given time. Actual reserves include cash on hand, cash in vaults, and deposits held with the central bank. Actual reserves are important because they represent the total amount of money that banks have available to meet demands for withdrawals, pay off debts, and make new loans. For example, if a bank has \(12,000 in cash on hand, \)5,000 in cash in vaults, and \(8,000 in deposits with the central bank, its actual reserves would be \)25,000.

Excess Reserves

Excess reserves are the difference between a bank's actual reserves and its required reserves. Excess reserves represent the amount of money that a bank has available for lending, investing, or meeting other obligations beyond what is legally required. Banks typically hold excess reserves to ensure they have enough liquidity to cover any unexpected withdrawals or other cash outflows. For example, if a bank has \(25,000 in actual reserves and \)10,000 in required reserves, it has $15,000 in excess reserves available for lending, investment, or other purposes.

Key concepts

Required Reserves

Every bank must hold a certain amount of cash, known as "required reserves." This amount is set by central banks, like the Federal Reserve in the U.S., and ensures that banks can pay customers who want to withdraw money. Required reserves are determined as a percentage, called the "required reserve ratio," of the bank's total deposits. This means a bank cannot lend out all the money deposited with it; a part of it must be kept aside as a safety net.
For instance, if a bank's deposits total $100,000 and the required reserve ratio is 10%, the bank must keep $10,000 in reserve and can only lend out the remaining $90,000. This rule helps maintain financial stability by ensuring banks have a steady cash flow to handle withdrawals.

Actual Reserves

The amount of real money a bank holds at any time is called "actual reserves." These include cash in the bank's vaults, cash on hand, checks that are ready to be drawn, and deposits at the central bank. Actual reserves show how much money a bank can use to meet withdrawal demands, pay off debts, or make new loans.
For example, if a bank has $12,000 in cash, $5,000 in checks, and $8,000 in deposits at the central bank, then its actual reserves total $25,000.

• This ensures the bank can cover its financial responsibilities.
• Helps in determining how much it can lend or invest beyond required reserves.

Excess Reserves

After meeting the required reserves, the extra money a bank holds is known as "excess reserves." These are crucial because they provide the bank with a cushion for unexpected withdrawal requests or investment opportunities. Excess reserves represent the amount that a bank can safely use for lending or investing without risking its ability to meet customers' withdrawal demands.
For instance, if the total actual reserves are $25,000 and the required reserves are $10,000, the excess reserves available for lending or investing amount to $15,000.

• Offers a buffer to enhance liquidity.
• Allows banks more flexibility in managing their financial resources.

Central Bank Regulations

Central banks regulate the banking sectors to ensure the stability of the financial system. One of their main tools is setting reserve requirements. These requirements dictate how much money a bank must keep in reserve, influencing how much money is available for lending and borrowing.
By adjusting the required reserve ratio, central banks can help control inflation and manage economic growth. A lower reserve ratio can stimulate the economy by allowing banks to lend more money, while a higher ratio may slow down economic activity by restricting the amount that banks can lend.

• Helps maintain a balance between economic growth and price stability.
• Ensures banks remain solvent and prevents financial crises.

By setting these regulations, central banks play a crucial role in maintaining economic stability and public confidence in the financial system.