The Role of Bank Reserves

The role of bank reserves requires frequent explanation, because of widespread misunderstanding.

Bank reserves do not act as a form of money. They never have. When people used gold as a form of money, and banks had 100% reserves, banks would hold gold to back the claims represented by banknotes or checks. While held as reserves, gold no longer played the role of money. Only after the holders of banknotes and checks exercise their claim on gold (at which time the holder's claim on the gold would be canceled) with the gold return to its former role as money. Gold and banknotes/checks would never play the role of money at the same time.

This relationship has not changed in the modern banking system, in which we have fractional reserve banking and reserves created by the Federal Reserve. Bank reserves still do not play a role as money. They act more like a control mechanism on the ability of banks to create money.

In an hypothetical situation in which banks must hold a reserve equal to 50% of their deposit liabilities, a bank with $1,000 in reserves (2,000 reserve dollars) could create 2,000 money dollars (I use the phrase money dollars to distinguish them from dollars held as bank reserves). If the Federal Reserve created another thousand dollars in reserves, to pay for assets they acquired from the bank, the bank would have no obligation to create another 2,000 money dollars.

Historically, because of the relatively low level of bank reserves, when the Fed increased the quantity of reserves, banks would have sufficient demand for money that they would buy an adequate number of notes to fully use the capacity of their moneymaking capability. With the massive run-up in bank reserves during the financial crisis of 2008, banks no longer had access to a sufficient number of quality notes to use their full moneymaking capacity.

Conclusion

Although the role of bank reserves has played a very important part in the structure of banking over the years, they are frequently misunderstood. I have only touched on the subject briefly in this post and will probably return to it several times in future blog posts.