Reserve Requirements for Demand Deposits
Reserve requirements constitute a percentage of total deposits that banks receive, which need to be kept on hand to offset losses that the bank may incur and also to help stabilize the banking industry. The Board of Governors, which is a branch of the Federal Reserve System, determines reserve requirements. Reserve requirements can also be used as a monetary tool designed to generate certain activity in the economy.
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Reserve Requirements
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Banks are required to keep 10 percent of all deposits on hand as reserve requirements. The reserves can be kept in the banks' cash vault or on deposit with a Federal Reserve Bank. If the reserve requirements are increased, banks have less money to lend, which in turn shrinks the money supply. When reserve requirements are lowered, banks have more money to lend, which helps to expand the amount of money in the economy.
Borrowed Funds
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Sometimes a bank doesn't have enough money on hand to meet its reserve requirements. In such cases, the bank borrows money from banks that don't have a shortage of funds. This money is usually borrowed overnight and the lending banks charge a rate of interest for the borrowed funds. The interest rate charged is called the federal funds rate and is set by the Board of Governors; the federal funds rate is currently .25 percent.
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Discount Rate
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Another way for banks to replenish their reserve requirements is to borrow the money directly from a Federal Reserve Bank. They still incurs the cost of borrowing the funds, called the discount rate. This rate is slightly higher than the federal funds rate. The Federal Reserve can also use this rate to influence activity in the economy.
Monetary Control
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Whenever the economy begins to grow, inflation can also increase beyond desirable levels. As a result the Federal Reserve may increase reserve requirements for banks, which means they must keep more money on hand, leaving less money to lend. This causes the money supply to shrink and interest rates to rise in the short term; inflation is brought under control in the process.
Interest
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In the past, banks did not receive any interest for the reserve requirements they had on hand. Effective October 2008 the Federal Reserve changed this policy and interest is now paid at a rate of .25 percent. Interest is also paid to any bank that has funds available in excess of its reserve requirements.
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