Issue & Impact of FRS Reserve Requirements

The purpose of this research is to examine the issue of reserve requirements mandated by the Federal Reserve System and their impact on monetary policy. The plan of the research will be to set forth the relevance of reserve requirements to money and financial markets and to discuss the logical and substantive strengths and weaknesses of various treatments of the subject.

"Fedpoint 45: Reserve Requirements," a publication of the New York Federal Reserve Bank, presents a straightforward description and explanation of funds that, as the term implies, banks are obliged to keep in reserve, i.e., unavailable for lending or investment. The relevance of reserve requirements to money and financial markets, from the point of view of the financial institutions, is that the reserve requirements represent an opportunity cost to the banks inasmuch as those funds that might be used for lending or investment are not available to the banks but must lie idle "as vault cash or on deposit at a Federal Reserve Bank" (FRBNY, 1997, p. 1). The reserve requirements are also a real cost to the banking system inasmuch banks must forgo the beneficial use of reserved funds for other profit-making purposes. On the other hand, reserve requirements can be viewed as a leverage against risk of absolute insolvency, a cushion of cash in the event of financial emergency. The reserve requirements are relevant to money and financial markets from the point of view of the Fed, inasmuch as the reserves "are used i

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erves maintained there but that Congress has customarily opposed such payments, which would represent "an additional expense to the Fed" (FRBNY, 1997, p. 3), and by extension a drain on the U.S. Treasury. In point of fact, disagreement and controversy surround Fed authority and activity regarding monetary policy on a variety of issue fronts. Nor is such controversy confined to the question of paying interest on reserves maintained at the Fed. Sellon and Weiner suggest that the very use of reserves as a linchpin of monetary policy has weakened in recent years. Control of reserves as a strategy of monetary policy, they argue, has been largely replaced by control of short-term interest rates (1996, p. 5). They cite the reduction or elimination of such requirements on various categories of accounts. On its face, this suggests that depository institutions are at less disadvantage than previously where the availability of investment and lending funds is concerned. However, consider the obvious fact that, irrespective of Fed reserve requirements, banks as credible financial institutions require a cushion of cash; the difference is that the cushion is not confined to use by the Fed but rather is necessary to effect settlements (Sellon

Category: Economics - I