We often hear in the news of the Fed changing the interest rate. Why do they not commonly alter the reserve ratio?

Won't either be capable of expanding or contracting the money supply?


The operating procedures the Fed has followed has changed over the years. I will first discuss the situation pre-2008, and then discuss the current situation.

Situation 1994-2008.

The Fed has an interest rate target, and the amount of excess reserves in the system was typically very small. Under normal circumstances, the Fed controls the amount of reserves in the system with open market operations. If nothing else happens, if the Fed buys \$1 billion in securities, it will create \$1 billion in reserves. (Exceptions include: banks may exchange reserves for notes and coins, and if there was a shortage of reserves, banks would be forced to go to the discount window to borrow to meet reserve requirements.)

In other words, the Fed has to supply whatever reserves are required by the banking system. Banks lend first, then search for reserves later. If there is a shortage in the system, the Fed has to create reserves to meet demand, or else the interbank rate will go above target.

This means that reserves follow lending decisions, and the only influence the Fed has on the level of the money supply is through the moderating effect of interest rates on expectations.

Note that this explanation is known as "endogenous money", as opposed to "exogenous money", and which version is correct is/was a major debate. The endogenous money stance seems to be closer to the modern consensus; Monetarists were the main propenents of exogenous money. I believe that the modern version of "exogenous money" is more complex than the old belief (the central bank directly sets the level of the money supply), and the short-term story ends up being similar to my description above. Unfortunately, undergraduate textbooks tend to push the old exogenous money story.

From this standpoint, changing the reserve ratio will do very little, it just changes the amounts of reserves that the Fed has to create/destroy in order to hit its interest rate target. The reserve ratio has an effect on the competitive position of banks versus non-bank financial firms, and so reserve ratio changes end up having a distorting effect on competition.

The general irrelevance of reserves in monetary policy explains why reserve requirements were abolished in many developed countries, such as Canada.

The current situation features large amounts of excess reserves; changing the reserve ratio would imply no change in policy, as all that happens is that some existing reserve positions are reclassified, with no other effect.


There was a time when they did, but it's a less common tool of monetary policy now. At any rate, altering the minimum reserve ratio at this point would be pointless due to the huge quantities of excess reserves banks have been holding since the 2008 bailouts and subsequent rounds of quantitative easing. The reserve ratio is a relevant tool of monetary policy only if banks are actually at or near that ratio, which few are at this time.


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