Reserve Requirements

The Fed also influences the money supply with reserve requirements, which are regulations on the minimum amount of reserves that banks must hold against deposits. Reserve requirements influence how much money the banking system can create with each dollar of reserves. An increase in reserve requirements means that banks must hold more reserves and, therefore, can loan out less of each dollar that is deposited; as a result, it raises the reserve ratio, lowers the money multiplier, and decreases the money supply. Conversely, a decrease in reserve requirements lowers the reserve ratio, raises the money multiplier, and increases the money supply. The Fed uses changes in reserve requirements only rarely because frequent changes would disrupt the business of banking. When the Fed increases reserve requirements, for instance, some banks find them selves short of reserves, even though they have seen no change in deposits. As a result, they have to curtail lending until they build their level of reserves to the new required level.

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