Reserve requirements, which have been imposed by most central banks, can be rationalized on several grounds. First and foremost, they may help to stabilize the demand for base money and thus facilitate the use of other instruments in the implementation of monetary policy. In the absence of more flexible instruments, reserve requirements may themselves be varied as a means of implementing monetary policy. Reserve requirements have a fiscal impact insofar as they require banks to hold an asset that yields less than the market rate of return; they are an inefficient means of taxing financial services if alternatives are available. Finally, reserve requirements can be used to ensure that banks hold a prudent level of liquid assets.
The design of reserve requirements can strongly influence their effect on banks’ behavior. It is normally most efficient to define the reserve base to include all and only those bank liabilities that are included in the targeted monetary aggregate. Most arguments suggest that the reserve base should be measured contemporaneously with the holding period, or designed to approximate a contemporaneous requirement, and that a bank’s compliance with reserve requirements should be based on the average of its reserve holdings. For efficiency, the remuneration of reserves should be set close to their opportunity cost--that is, the safe lending rate--adjusted for the proportion of reserves held voluntarily. Assets eligible to fulfill the requirement may or may not include cash in vault. The penalty for noncompliance should be explicit: the penalty rate needs to be at least twice the opportunity cost to be effective.