The Federal Reserve System

Reserve Requirements

Under what circumstances would the Fed want to change the reserve requirement for banks? The purpose of controlling the money supply is primarily to lessen the threat of inflation (a rise in the overall price level) or recession (an economic slowdown gauged by a decline in gross domestic product). Here's how it works (again, in theory). If the Fed raises the reserve requirement (for example, from 10 percent to 11 percent), banks must set aside more money. Consequently, they have less to lend and so raise their interest rates. Under these conditions, it's harder and more expensive for people to borrow money, and if they can't borrow as much, they can't spend as much, and if people don't spend as much, prices don't go up. Thus, the Fed has lessened the likelihood of inflation.

Conversely, when the Fed lowers the reserve requirement (for example, from 10 percent to 9 percent), banks need to set aside less money. Because they have more money to lend, they keep interest rates down. Borrowers find it easier and cheaper to get money for buying things, and the more consumers buy, the higher prices go. In this case, the Fed has reduced the likelihood of a recession.

A 1 percent change in the reserve requirement, whether up to 11 percent or down to 9 percent, may not seem like much, but remember our earlier discussion of the money multiplier: because of the money-multiplier effect, a small change in the reserve requirement has a dramatic effect on the money supply. (For the same reason, the Fed changes reserve requirements only rarely.)