Which of the following is the correct formula for calculating excess reserves?

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The lecture focused on the banking system and included a discussion about total reserves, required reserves and excess reserves. Students practiced calculating each category in pairs and then compared their solutions with those of the instructor.

Learning Goals

Students will:

• calculate required reserves and excess reserves;
• recognize how total reserves, required reserves, and excess reserves are related to each other;
• interpret the impact to required reserves and excess reserves because of a change in total reserves.

Context for Use

This exercise is appropriate for any institution type or class size. It can be used in class by students working individually or in groups of two to three students. It can also be used as part of a homework assignment. It can be used in a Principles of Macroeconomics class or in a Money and Banking course. Students will need a basic understanding about the fractional reserves banking system and the terms total reserves, required reserves, and excess reserves.

Description and Teaching Materials

For this assignment, a MC, T/F or short answer question is needed. The question should require students to use an analytical process to arrive at the answer. For example,

Suppose a bank has total deposits of $500 million. If the required reserve ratio is 12 percent and the bank's total reserves are equal to $100 million, the level of excess reserves is equal to:
a) $40 million.
b) $60 million.
c) $100 million.
d) $400 million.

Answer: a

Teaching Notes and Tips

Students must be able to define the terms total reserves, required reserves and excess reserves. They also need to understand how to calculate each term and understand how the terms are related to each other. It's important for students to recognize that total reserves are composed of required reserves plus excess reserves. The other calculation they sometimes are confused by is how to determine required reserves. Using a simple T-account is a visual method to demonstrate the relationships.

Assessment

Students should be told to write a documented problem solution for the question, focusing on the process used to solve the question. A sample documented problem solution:

1. First I reviewed the definitions and formulas for total reserves, required reserves and excess reserves.
2. Then I looked at the T-account that was presented in class.
3. I know that in order to calculate required reserves, total bank deposits must be multiplied by the required reserve ratio.
4. In this case, bank deposits are $500 million multiplied by the required reserve ratio of 0.12 which equals $60 million in required reserves.
5. I also know that required reserves plus excess reserves must equal total reserves.
6. Total reserves are given as $100 million, and required reserves are calculated as $60 million. In order for required reserves plus excess reserves to equal total reserves, excess reserves must be equal to $40 million.

References and Resources

Angelo, T.A. and Cross, K.P. (1993). Classroom Assessment Techniques: A Handbook for College Teachers. San Francisco: Jossey-Bass.

Excess reserves refer to the surplus of cash a bank holds in its vault or Fed account beyond what is required by the Federal Reserve to be on hand.

Anytime a bank keeps more money on hand than is required by regulation, it is known to have excess reserves. Banks typically hold excess reserves in times of financial uncertainty or if they believe interest rates will fall.

Here’s a closer look at how excess reserves work, why they are held, and what they mean for you as a banking customer.

Definition and Examples of Excess Reserves

Excess reserves refer to the surplus of cash a bank holds in its vault or Fed account beyond what is required by the Federal Reserve to be on hand.

Note

The Federal Reserve, or Fed, is the U.S. central bank in charge of managing the money supply and interest rates in the country. It has many tools at its disposal to do this job. One such tool is changing the amount of money commercial banks must keep on reserve.

For example, suppose a bank is required to keep 10% of its deposits in reserve. If a bank has 12% in its reserve, then it has an excess reserve of 2%. The bank is free to use these funds for any purpose.

How Do Excess Reserves Work?

Banks make money by taking in deposits from customers, then lending that money back out to others at a higher interest rate. They can’t lend out all their money, though, because they need liquid cash on hand to pay their bills and fulfill withdrawal requests from customers.

The Federal Reserve tells depository institutions the minimum amount of money they must keep available for financial obligations. This minimum is known as the reserve requirement. Any money banks keep over this limit is considered excess reserves.

Banks don’t lend excess reserves to businesses or consumers. Rather, they hang onto them in case of emergency.

The excess reserves formula looks like this:

Excess Reserves = Total Reserves - Required Reserves

In essence, a bank’s excess reserves are any cash it keeps over the required minimum. For example, suppose a bank has $20 million in deposits. If its reserve ratio is 10%, then it’s required to keep at least $2 million on hand. However, if the bank has $3 million in reserves, then $1 million of it is in excess reserves.

On the other hand, if a bank has $2 million in reserves and is required to keep $2 million on hand, then it has zero excess reserves.

Why Do Banks Hold Excess Reserves?

You may be wondering “What’s the significance of excess reserves? Why do banks use them?” At their core, excess reserves act as a safety net for banks during times of economic uncertainty. The bank can fall back on this buffer if loans default or a lot of customers withdraw money at once.

Think of it like this: If you knew a hurricane was headed your way, you’d stock up at the grocery store and fill your pantry with all types of necessities to prepare for the unexpected. Banks do the same thing when they hold excess reserves.

Note

Excess reserves in the U.S. doubled early in the pandemic, soaring from $1.5 trillion in February 2020 to $3.2 trillion in May 2020. This is a prime example of how banks prepared for the financial uncertainty of the sweeping event.

As a banking customer, you usually don’t know when your institution has excess reserves. All you know is that you can withdraw or transfer money whenever you need it. In a sense, this is what having excess reserves is all about—making sure you always have a smooth banking experience, no matter what’s going on in the world.

Required Reserves vs. Excess Reserves

Required ReservesExcess ReservesThe minimum cash a bank must keep on hand, as dictated by the Federal ReserveThe additional cash a bank keeps on hand over the Fed’s required minimumEnsures banks have enough cash on hand to fulfill financial obligations and withdraw requests during regular economic timesUsed as a buffer in times of economic uncertainty to protect the bank from unexpected financial losses

Banks must keep a certain percentage of their deposits on reserve in a vault or with their local Federal Reserve branch. This minimum is the required reserve. If the bank chooses to hold onto additional money over this threshold, then it has excess reserves.

Just as you earn interest on your savings account balance, banks also earn interest on their required reserves and excess reserves. The Federal Reserve sets these interest rates.

Key Takeaways

• Excess reserves are the additional amount of money a bank keeps on hand over the reserve requirement.
• Excess reserves are important because they act as a safety net during times of economic uncertainty, ensuring the bank has enough money on hand to pay bills and honor withdrawals.
• You can calculate excess reserves by subtracting a bank’s required reserves from its total reserves.

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Sources

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.

1. Federal Reserve Bank of San Francisco. “I Noticed That Banks Have Dramatically Increased Their Excess Reserve Holdings. Is This Buildup of Reserves Related to Monetary Policy?” Accessed Jan. 26, 2022.

2. Federal Reserve Bank of St. Louis. “Excess Reserves of Depository Institutions.” Accessed Jan. 26, 2022.

   What is the formula for calculating excess reserves?

   You can calculate excess reserves by subtracting a bank's required reserves from its total reserves.

   What is the value of excess reserves?

   Excess reserves refer to the cash held by a bank or other financial institution above the reserve requirement that an authority sets. The amount of excess reserves is equal to the total reserves reduced by the required reserves.

   What is excess reserve in economics?

   Excess reserves—cash funds held by banks over and above the Federal Reserve's requirements—have grown dramatically since the financial crisis. Holding excess reserves is now much more attractive to banks because the cost of doing so is lower now that the Federal Reserve pays interest on those reserves.