reserve requirement

When you deposit 1,000 dollars at a bank, the bank does not lock it in a vault — it lends most of it out to others, keeping only a fraction on hand in case some depositors want their money back. A reserve requirement is a rule from the central bank saying exactly what minimum fraction a bank must hold back as reserves and not lend out. If the requirement is 10 percent, a bank holding 1,000 dollars in deposits must keep at least 100 dollars in reserve.

By raising or lowering this required fraction, a central bank can in theory turn lending up or down. A lower requirement frees banks to lend more of each deposit, expanding credit and the money supply; a higher requirement forces them to hold more back, shrinking lending. The reserve requirement is also the gear behind the 'money multiplier': because each loan becomes someone else's deposit, which is again partly lent out, a small base of reserves can support a much larger stock of bank money — and the lower the required ratio, the larger that multiple can grow.

In modern practice, however, reserve requirements have faded as an active policy tool. Many central banks change them rarely or have abolished them entirely — the United States set its reserve requirement to zero in 2020 — preferring to steer the economy through the policy interest rate and the interest paid on reserves, which are far more precise. So the reserve requirement is conceptually important for understanding how banks create money, but in many countries today it is no longer the lever it once was.