What is a reserve requirement?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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In economics, the reserve requirement is the percentage of deposits that banks are required to actually keep in the bank in liquid form. 

When people deposit money in a bank, the bank does not want to simply hold on to that money.  If it did, it would not make any profit.  What the bank does, instead, is loan out the money.  The bank makes most of its money by issuing these loans. The more money the bank loans out, the more money it is likely to make.

But the government does not want the banks to loan out too much of their money.  If the banks do loan out too much money, they might not have enough on hand to satisfy customers who want to withdraw their money.  This is especially likely to happen if the economy goes bad and borrowers start to default on their loans.

To prevent this, governments impose a reserve requirement. Theoretically, the reserve requirement can be changed to affect the money supply (as part of monetary policy) but this is rarely done in practice.

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