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Reserve

The Federal Reserve mandates that the nation’s banks set aside a part of their assets as cash in reserves; basically, they keep a certain amount of cash in their vaults or on deposit with the Federal Reserve. Cash in this context does not really mean physical printed money, but instead a computerized system of credits. Who deals with real cash these days anyway? The reserves are kept in check by the Federal Reserve, and the banks are not allowed to withdraw from their reserves beyond a certain point. This is referred to as meeting the reserve requirement.

The reserve is the only tool available to the Federal Reserve to regulate the banks and thus to regulate the amount of cash flow in the public domain by raising and reducing the reserves or the reserve requirements for the banks. Adding to a bank’s reserve, or setting a lower limit on its reserve requirement, provides the bank with more money to loan out to the public, in effect injecting cash into the economy. (Banks usually try to loan out as much money as they can because reserves do not collect interest.) This is known as loosening or easing of the Monetary Policy. On the other hand, reducing the bank’s reserve, or increasing its reserve requirement has the effect of withdrawing cash from the economy since banks are left with less money to loan out. This is known as tightening the Monetary Policy.

It becomes clear why interest rates fluctuate when we consider the effects of supply and demand. Given a steady demand, more cash supply in the economy results in lower interest rates because there is more money around to borrow. Conversely, less cash supply in the economy elevates the interest rates as there is less money around to borrow. …