Definition: The Fed's reserve requirement refers to the amount of deposits that a bank must keep on hand at all times. Each night, the bank must make sure it has the reserve requirement on hand. If not, it can borrow from other banks or the Federal Reserve discount window to meet the requirement.
The reserve requirement is another tool the Fed uses to control liquidity in the market. A low reserve requirement is expansionary monetary policy, since it allows more money in the banking system. A high reserve requirement is contractionary, since it allows less liquidity, and slows down economic activity.
The higher the reserve requirement is, the less profit a bank makes on its money. A high requirement is especially hard on small banks, since they do not have as much to lend out in the first place. Every time the Fed changes the requirement, banks have to make changes to their policies, which incurs a cost. For these reasons, the Fed rarely changes the reserve requirement.
Examples:
As of December 2006, the reserve requirement was 10% on transaction deposits.
