Reserves are necessary as part of the fractional reserve banking system that most financial institutions use internationally. The central bank is responsible for setting the minimum reserve requirement for commercial banks, meaning that these banks must hold a small percentage of the money deposited by their customers in their accounts, while still being able to make loans with the rest of the money.
Central banks set the rates of interest charged to member banks when they advance credit through short-term loans. The member banks are responsible for offering loans to businesses and consumers for mortgages, vehicles, business expansion, equipment, and other large purchases. They also sell bonds at set interest rates. The central bank’s interest rate is meant to guide commercial banks in their lending activities. When the interest rate is low, banks are more likely to loan more money. But when the central bank raises the rates, member banks tighten their lending practices.
Member banks sell and buy securities from the central bank (e.g., government bonds and mortgage-backed securities). When a central bank buys securities from its member banks, it gives the commercial banks more cash to loan to their consumers. In recent economic crises, central banks have used this method in attempts to help in economic recovery through quantitative easing (QE). In short, QE strategies “created” new money by adding currency to a bank’s financial reserves through credit.
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