The Real Effects of Reserve Requirements

We review arguments for and against reserve requirements and conclude that the main question is whether a distinction between money creation and intermediation can be made. We argue that such a distinction can be made in a money-in-advance economy and show that if the the money-inadvance constraint is universally binding then reserve requirements on checkable accounts have no effect on intermediaiton. We then proceed to show that in a model in which trade is uncertain and sequential, a fractional reserve banking system gives rise to endogenous monetary shocks. These endogenous monetary shocks lead to fluctuations in capacity utilization and waste. When the money-in-advance constraint is universally binding, a 100% reserve requirement on checkable accounts can eliminate this waste. * The University of Haifa. We would like to thank Larry Christiano, Marty Eichenbaum, Bob Lucas and Art Rolnik for useful discussions and comments on a previous version of this paper.