Curiosity 7.1: What Is the Balanced-Budget Multiplier?

		Curiosity 8.3: What Are the Legal Reserve Requirements?

		The Fed imposes reserve requirements for all depository institution of 3 percent on an institution's first $46.5 million of checkable deposits, and 10 percent thereafter. It has the power to vary this rate between 8 and 14 percent. There are no reserve requirements on other deposits (such as term deposits). By changing the reserve requirements, the Fed can affect the money supply. Decreasing the required reserve ratio causes the commercial banks suddenly to find themselves with excess reserves, so they can increase loans, thereby expanding the money supply. Increasing reserve requirements causes a contraction in the money supply. Changing the required reserve ratio is a very blunt way of affecting the money supply, however, so it is rarely used.

		Many countries such as Canada, Switzerland, New Zealand, and Australia have no reserve requirements at all. Banks in these countries still old reserves to deal with the their everyday cash requirements and are immediately loaned extra reserves by their central bank (at a very high price) should they experience an embarrassing shortfall of cash, so there is no danger of banking disasters. By eliminating reserve requirements these countries strengthen their banks' ability to compete in a multinational banking environment.

		increases and decreases in their vault cash as cash is deposited or withdrawn. They know from experience, however, that the amount of cash they must have on hand to deal with withdrawals of cash is a small fraction of total deposits, and so they limit the money they create (loans they make) to ensure that their reserves of cash are at least this fraction of total deposits.

		The implication of all this for the money supply is best explained by means of an example. Suppose banks figure their cash requirements should be 5 percent of total deposits. If the banking system's cash holdings are $40 billion, then the banks will increase loans until the amount of deposits, and thus the money supply, is $800 billion. (Five percent of $800 billion is $40 billion.) Because the central bank (the Fed) creates cash, any balances in the commercial banks' accounts with the Fed are just as good as cash. This fact implies that the reserves held by banks to handle possible cash disbursements can be either cash or balances in their accounts at the central bank. (Such balances are called claims on the central bank.) The money supply is thus a multiple of these reserves, which are controlled by the central bank. Because such reserves are a fraction of the total money supply, this banking system is called a fractional-reserve banking system.

		There is an obvious danger inherent in such a banking system. Because a smaller percentage of reserves means a greater quantity of loans and therefore more profits, there is a temptation for banks to underestimate the fraction of reserves they should hold. This increases the chances of being unable to meet requests for cash, with the consequent financial ruin of the bank should depositors panic and create a run on that bank. Government regulation of banks, including deposit insurance and the setting of a reserve requirement, arose because of such banking disasters and because the government wanted to be able to control the total amount of money circulating in the economy to affect the pace of economic activity.