I initially thought it was just a cut of the interest payment from your loan to the bank that the government kept to manage inflation and everything. But then I heard about how it affects the overnight money market. What does the reserve rate actually do? And how does it affect loan and savings account interest rates?
In: Economics
The reserve rate isn’t an interest rate…it’s how much of the deposited cash the bank has to keep on hand (rather than loaning it out).
Suppose a bank has $1B in deposits. They don’t actually keep $1B inside the bank. They keep *some* so they can give you cash when you make a withdrawal and they loan the rest out to make money. This is why a “bank run” (everyone withdrawing their money at once) kills the bank…they don’t actually have everyone’s money all the time.
The central bank sets a minimum percent of deposits that the bank must keep on hand…”in reserve”, that’s the reserve rate.
This impacts the overnight money market because if a bank has more cash on hand than their reserve requires they can loan the excess out. If they’re short they need to borrow to get back up to the reserve rate.
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