DEFINITION of 'Free Reserves'

Free reserves are the reserves a bank holds in excess of required reserves, minus reserves borrowed from the central bank. 

BREAKING DOWN 'Free Reserves'

Under fractional reserve banking, commercial banks only hold a limited amount of their total funds in a liquid form at any given time. In other words, not all deposits are kept on hand in cash; most are lent out or otherwise invested. U.S. federal law requires banks to hold a certain portion of their funds in cash vaults or in Federal Reserve Bank accounts. Excess reserves, on which the Fed pays interest, are reserves that exceed these requirements. Borrowed reserves are those that banks borrow from the Federal Reserve at the discount rate.

Subtracting borrowed reserves from excess reserves yields a bank's free reserves, which are available to be lent out.

More free reserves a mean more available bank credit, which in theory lowers the cost of borrowing and leads to inflationary pressures. Free reserves rose to unprecedented levels following the financial crisis, when the Fed offered to pay interest on banks' excess reserves. This development coincided with an unprecedented cut in the federal funds rate to near-zero, but these policies have not spurred inflation because of a prevailing deflationary environment. The increase in Fed liabilities caused by rising free reserves has been more than balanced out by the assets the Fed created through quantitative easing.

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