The effect of bank reserve requirements on lending volume and interest rates faced by borrowers

In the aftermath of the 2008 Financial Crisis, policymakers have been forced to consider options that strengthen the financial system and safeguard the assets of depositors. However, policymakers have also been charged with promoting economic recovery. Reserve requirements impact both in that raising such requirements would promote stability, but would come at a cost in terms of shrinking the monetary aggregate, specifically M1 and M2. This paper studies the relationship that raising or lowering the reserve requirement has on aggregate lending volume and interest rates faced by borrowers in the marketplace. It concludes that raising the reserve requirement is associated with a significant decrease in aggregate lending volume and a significant increase in market interest rates. These results are useful to policymakers seeking to strike a balance between promoting policies that strengthen the financial system and also promote an expedient economic recovery.