Reserve Requirements

B is correct. While the 0% reserve requirement technically removes the regulatory floor, banks still voluntarily hold significant reserves for several reasons: managing daily liquidity needs, meeting customer withdrawal demands, and earning interest on reserve balances (IORB) paid by the Fed. The Fed shifted to other monetary policy tools (open market operations, discount rate, and IORB) to control money supply, making reserve requirements obsolete as an active policy lever.

A is incorrect because the Fed did not raise rates when reserve requirements went to 0% in March 2020. In fact, the Fed lowered rates to near-zero during the pandemic response. Additionally, banks face many other lending constraints beyond reserve requirements (capital requirements, credit risk assessment, loan demand, etc.). C is factually wrong: the 0% requirement applies to all depository institutions of all sizes, not just small banks. D confuses monetary policy tools with prudential regulation. Capital requirements (like Basel III standards) serve a safety and soundness purpose (ensuring banks can absorb losses), not the same monetary policy function as reserve requirements (controlling money supply).

D is correct. Since March 26, 2020, the Federal Reserve has set reserve requirements to 0% for all deposit types at all depository institutions. This action was taken during the COVID-19 pandemic and has remained in effect, effectively eliminating reserve requirements as an active monetary policy tool.

A (3%) was historically the reserve requirement for transaction accounts in the middle tier ($16.9M-$127.5M) before March 2020, but is no longer applicable. B (5%) was never a standard reserve requirement percentage in the modern era. C (10%) was the historical requirement for transaction accounts over $127.5 million before March 2020, but this tiered structure was eliminated when requirements went to 0%.

B is correct. Lowering reserve requirements is an expansionary monetary policy action. When the Fed reduced the required reserve percentage from 10% to 8%, banks were required to hold less money in reserve and could lend out more of their deposits. This increases the money supply in the economy through the money multiplier effect, stimulating lending, spending, and economic growth. The Fed would use this tool during economic slowdowns or recessions.

A is backwards: lowering reserve requirements expands (not contracts) the money supply. Contractionary policy would involve raising reserve requirements. C is incorrect because reserve requirement changes significantly affect money supply through the lending multiplier. They are not neutral and serve a monetary policy purpose, not just a safety function (though they do contribute to bank stability). D is completely backwards: lowering reserve requirements allows banks to hold less in reserve and lend more, not less. This answer confuses the direction of the policy action.

C is correct (the EXCEPT answer). This statement is FALSE. Lowering reserve requirements is an expansionary monetary policy tool, not contractionary. When the Fed lowers reserve requirements, banks can lend out a larger percentage of their deposits, increasing the money supply and stimulating economic growth. Contractionary policy (used to combat inflation) would involve raising reserve requirements to restrict lending and reduce money supply.

A is accurate: reserve requirements are set by the Federal Reserve Board of Governors through regulatory authority granted by Congress. Individual banks cannot set their own reserve requirements, and while Congress established the Fed's authority, it does not set specific reserve requirement percentages. B is accurate: this is the fundamental definition of reserve requirements. They establish what portion of deposits must be held as reserves (vault cash or deposits at the Fed) versus what can be lent to borrowers. D is accurate: the Fed reduced reserve requirements to 0% on March 26, 2020, and this remains the current policy. This effectively eliminated reserve requirements as an active monetary policy lever.

B is correct. Statements 1, 2, and 4 are accurate.

Statement 1 is TRUE: Raising reserve requirements is contractionary monetary policy. By forcing banks to hold more money in reserve, the Fed reduces the amount available for lending, which decreases the money supply and slows economic activity.

Statement 2 is TRUE: Calculate the required reserves: $200 million × 0.05 (5%) = $10 million. The bank must hold $10 million in reserve (as vault cash or deposits at the Fed), reducing the amount available for loans from $200 million to $190 million.

Statement 3 is FALSE: Raising reserve requirements decreases the money supply, not increases it. When banks must hold more in reserve, they have less to lend out. This reduces the money multiplier effect and contracts the overall money supply in the economy.

Statement 4 is TRUE: The Fed would use contractionary policy (like raising reserve requirements) to combat inflation. By reducing money supply and making credit less available, the Fed can cool down an overheating economy and reduce inflationary pressures. Raising reserve requirements would make borrowing more difficult and expensive, slowing spending.