Changes in Required Reserves

The Fed can change
reserve requirements if it wants to change the money. For instance, if wants tighten money overnight, it can raise the required reserve ratio on checking accounts for the big banks to the 14 percent statutory limit. It might even raise reserve requirements on time deposits. Exactly how does anon crease in required ratios operate to tighten credit? Suppose the required reserve ratio is 10 percent and banks had ‘built up their’ reserves.to meet this requirement. Now suppose the Fed decides to tighten credit, and Congress allows it to raise the required reserve ratio to 20 percent. (This fantastic figure is for algebraic simplicity. The Fed cannot and would not take such a drastic step today.) “

Even if the Fed does nothing by way of open-market operations or discount policy to change bank reserves, banks now have to contract their loans and investment greatly-and their deposits as well. As the last chapter showed, bank deposits can now be only 5 times reserves, not 10 times reserves. So there must’ be a drop by one-half in all deposits!

Such an enormous change in so short a time would lead to very high interest rates, credit rationing, large declines in investment, and massive reductions in GDP and employment. So this extreme example warns that this powerful tool of changing reserve requirements has to be used with great caution. Changes in reserve requirements are made extremely
sparingly because they cause too large and abrupt a change in policy. open-market operations can achieve the same results in a less disruptive way.