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Explain how banks are financial intermediaries. What are reserves? What are excess reserves? Explain how the Fed can affect the quantity of excess reserves in the banking system.

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Banks are financial intermediaries because they gather money from depositors and lend it out to borrowers.  In doing so, they act as intermediaries between these two groups.  If I lend you money personally, there is no intermediary.  However, if you go to the bank and take out a loan, the bank is acting as an intermediary between you as the borrower and me (and all the other people who deposit money in the bank), whose money you are borrowing.

Banks do not lend out all of the money that they take in.  Instead, they keep some of the money in their possession.  The money that they keep and do not lend out is called their reserves.  The Federal Reserve tells the banks how much money (what percent of their deposits) they have to keep in reserve.  That money is called the banks’ required reserves.  If the banks keep more money than required, the extra money is called their excess reserves.  The Federal Reserve cannot really tell banks how much they should keep in excess reserves.  If the Fed lowers the reserve requirement, banks might keep more money in excess reserves, but they do not have to.  If the Fed raises the reserve requirement, banks might keep less money in excess reserves but, again, they do not have to do so.

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