Financial markets (that is, banks and other financial institutions) provide the link between savings and investment in the economy. A bank is a profit-making entity that takes in deposits from households and firms and makes loans to firms, households, and the government.
Banks can be fragile institutions. [***The fragility of banks is discussed in more detail in Chapter 7 "The Great Depression".***] They must ensure that their depositors are not worried that the bank might go out of business, taking their money with it. Banks do many things to ensure that their customers have confidence in them. Perhaps the most important is that they keep a certain amount of their assets in a very liquid form, such as cash. This means that if a depositor comes in to withdraw his or her money, the bank will be able to meet that demand. These liquid deposits are called the reserves of the bank.
Most banks in the United States are members of the Federal Reserve System. This membership comes with a responsibility to hold some fraction of deposits on reserve. This is called a reserve requirement. [***Current reserve requirements are at “Reserve Requirements,” Federal Reserve, accessed September 20, 2011, http://www.federalreserve.gov/monetarypolicy/reservereq.htm#table1.***] Reserve requirements limit the amount of deposits that banks are able to loan out to firms and households. Suppose a bank has $1,000 on deposit and the reserve requirement is 10 percent. Then the bank must hold at least $100 on reserve and can loan out at most $900. We say “at least $100” since the bank is free to hold more than 10 percent on reserve. In uncertain times, when a bank is unsure how many depositors are likely to want to withdraw their money, the bank may choose to keep reserves above and beyond the level required by the Fed.
What does a bank do if it finds itself with insufficient reserves on a given day to meet its reserve requirements? The answer is that it borrows—either from other banks or from the Federal Reserve itself. Because the Federal Reserve can influence the interest rates at which banks borrow, it can influence the behavior of banks.
- 1135 reads
