Reserve Requirements
The reserve requirement tells banks what percent of the money that is deposited must be kept in a sort of rainy day fund.
High reserve requirements keep banks safer, since if people rush banks demanding their money back, like the bank panic in 1929 preceding the Great Depression, banks will at least be able to pay back some of it immediately. The downside to a high reserve requirement is that it lowers the money multiplier, which makes it harder to get loans and reduces the overall money supply. This deters investment and slows long-term economic growth.
Example:
An alien from Mars shows up at a bank carrying a case full of $100,000 of freshly minted dollar bills. Since the alien is bringing his cash from somewhere other than Earth, the cash has not yet been accounted for in the money supply. By initally injecting this additional 100 grand into the money supply through the banks, what's the total effect on the money supply? Well, the money multiplier effect depends on the reserve requirement.
In the US, the Fed, a.k.a. the Federal Reserve, a.k.a. the central bank, keeps a watchful eye on Reserve Banks, who keep a watchful eye on commercial banks. Yep, it’s a hierarchy. If the Fed is like a royal family, then Reserve Banks are dukes and duchesses, and the commercial banks are aristocrats.
The Fed requires banks to meet “reserve requirements,” also known as the “cash reserve ratio,” which is the amount of money banks have to keep on hand. Why is this a rule? Well, part of what spawned the Fed into existence was a series of runs on banks from banking panics. A “run on a bank” is when everyone rushes to their bank and demands all of their deposits back. The thing is that one of the ways banks make money is by...lending out money. Yep, your money. Your deposits. For banks to make the most money possible, they would lend out as much money as they could...which, in theory would be all of it. But that leaves you, the depositor, without cash when you need it. The Fed wanted runs on banks to be a thing of the past (which they pretty much are now), so they established reserve requirements.
The money that banks are allowed to loan out are called “excess reserves.” For instance, a bank may be required to have 10% of its total money on hand, which would mean the remaining 90% of the money is excess reserves, which banks can lend out to turn a profit.
Now...here’s where the magic happens: multiple expansion of deposits. Multiple expansion of deposits is the theory that each deposit into a bank creates additional money made from excess reserve deposits as they are continuously lent out by, and re-deposited in, banks. There’s a literal multiplier effect that ripples outward into the economy called the “deposit expansion multiplier,” which estimates the maximum amount of money the Fed could expect a deposit injection into the economic system to create. This is how the Fed decides how much new money to pump into the economy, and the maximum effect they could possibly expect from that injection of money.
For instance, let’s say your bank has a 10% reserve requirement, leaving 90% in excess reserves. When that money is lent out, it’s deposited into another bank...eventually. So...let’s say you deposit a $2,000 check into your bank account. Your bank says “whoopee!” and lends out 90% of it, which is $1,800 (that other $200 they’re going to keep on hand for reserve requirements). Say that $1,800 is lent out to Climber Chris, who’s keen on climbing Everest. Climber Chris deposits that $1,800 into his bank account. Climber Chris’s bank says “whoopee!” just like your bank, and does the same thing: the bank lends out 90% of the $1,800, which is $1,620. The remaining 10% ($180) is kept at Climber Chris’s bank to meet reserve requirements. Climber Chris’s bank lends out $1,620 to Teacher Tina, who’s running short on school supplies and gas. Teacher Tina puts that $1,620 into her bank account. You can guess what Teacher Tina’s bank does. Yep, same as your bank, and same as Climber Chris’s bank, Teacher Tina’s bank lends out 90% of the money she deposited, which is $1,448, to Dan the Man...and so on and so on.
In this way, an initial deposit actually grows, providing more value than the initial amount deposited. Each time money is loaned out and redeposited, only 90% of that deposit gets turned into a new loan. We can keep taking 90% of the deposits (the maximum amount banks could loan out from that deposit) until the amount loaned out and deposited gets to pennies. You still have that $2,000 in your bank account that belongs to you. Meanwhile, Climber Chris has $1,800 that he can spend, and Teacher Tina has $1,620 that she can spend, which all came from your initial deposit.
How can $2,000 that was in your bank account multiply into additional value that other people can use in the economy? We told you that multiple expansions of deposits was magic. It literally expands the money supply. Remember that deposit expansion multiplier we mentioned earlier? It’s how the Fed can measure the maximum amount of money an initial injection of a deposit can be expected to create.
The deposit expansion multiplier is 1 divided by the reserve requirement. In our case, that’s 1 / 0.10...or 10. We can use the deposit expansion multiplier to see how much money your $2,000 deposit expanded the money supply. To figure out how much a deposit expanded the money supply, we multiply the expansion multiplier by the initial excess reserves. In our scenario, the reserve requirement is 10%, which gives us the deposit expansion multiplier of 10. Then we take the excess reserves from the initial deposit (you know, the 90% chunk of money that was created into the first loan for Climber Chis by your bank), which was $1,800. $1,800 x 10 = $18,000. 90% of your deposit was loaned out and deposited (to Climber Chris), then 90% of that was loaned out and deposited (to Teacher Tina), and 90% of that was loaned out and deposited (to Dan the Man), etc. If we assume the banks loaned out 90% at each stage, then it means the money supply was expanded by $18,000.
Yep. That means (assuming a reserve requirement of 10% for all commercial banks) that your initial deposit of $2,000 expanded the money supply by $18,000 in the economy. Yes, you can tell everyone “You’re welcome” now.
Okay...besides feeling like a money expansion superhero, why we care about multiple expansion of deposits? The Fed is in charge of keeping the economy healthy. One major way of doing that is by maintaining the money supply. You can think about the Fed as a doctor and the economy as a patient, with the money supply as blood pressure. A low blood pressure (a low money supply) means multiple expansion of deposits is low. Which means there’s less money flowing through the economy, which results in less spending, and slower economic growth. No like-y.
Blood pressure that’s too high (a high money supply) isn’t good either though. We’ve seen it before in history where a government just starts printing more and more money without the corresponding economic growth. What happens? Hyperinflation: prices of everything skyrocket, and money becomes almost useless...which is not good for the economy. That $2 milk? Now it’s $100. A month later, it’s $6,000. That’s not even an exaggeration…some places have faced hyperinflation of 3,000%.
The Fed’s job is to keep the economy’s money supply stable, which means it needs to be not too high, and not too low. When the Fed raises interest rates, it lowers the demand for loans, which lowers the amount of excess reserves loaned out, and slows the growth of the money supply from slower expansions of deposits. When the Fed lowers interest rates, it’s trying to increase demand for loans, encouraging the multiple expansion of deposits to grow the money supply.
Besides interest rates, the Fed can tinker with things like "stimulus packages" and other strategies to expand (or contract) the money supply. So now you know: money doesn’t grow on trees…but it does grow out of your bank account.