e a sizable imbalance between the supply of and demand for balances that might cause the federal funds rate to move significantly away from the FOMC s target. requirements have long been a part of America s banking history. Depository institutions maintain a fraction of certain liabilities in reserve in specified assets. The Federal Reserve can adjust reserve requirements by changing required reserve ratios, the liabilities to which the ratios apply, or both. Changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit and are also costly to administer; therefore, reserve requirements are not adjusted frequently. Nonetheless, reserve requirements play a useful role in the conduct of open market operations by helping to ensure a predictable demand for Federal Reserve balances and thus enhancing the Federal Reserve s control over the federal funds rate. depository institutions to hold a certain fraction of their deposits in reserve, either as cash in their vaults or as non-interest-bearing balances at the Federal Reserve, does impose a cost on the private sector. The cost is equal to the amount of forgone interest on these funds-or at least on the portion of these funds that depository institutions hold only because of legal requirements and not to meet their customers needs. burden of reserve requirements is structured to bear generally less heavily on smaller institutions. At every depository institution, a certain amount of receivable liabilities is exempt from reserve requirements, and a relatively low required reserve ratio is applied to receivable liabilities up to a specific level. The amounts of receivable liabilities exempt from reserve requirements and subject to the low required reserve ratio are adjusted annually to reflect growth in the banking system. Changes in reserve requirements can affect the money stock, by altering the volume of deposits that can be supported by a given level of reserves, and bank funding costs. Unless it is accompanied by an increase in the supply of Federal Reserve balances, an increase in reserve requirements (through an increase in the required reserve ratio, for example) reduces excess reserves, induces a contraction in bank credit and deposit levels, and raises interest rates. It also pushes up bank funding costs by increasing the amount of non-interest-bearing assets that must be held in reserve. Conversely, a decrease in reserve requirements, unless accompanied by a reduction in Federal Reserve balances, initially leaves depository institutions with excess reserves, which can encourage an expansion of bank credit and deposit levels and reduce interest rates. the 1960s and 1970s, the Federal Reserve actively used reserve requirements as a tool of monetary policy in order to influence the expansion of mon...
