Reserve Requirement

• Banks are required to keep a percentage of all deposits they take in, either in the cash vault or on deposit with the Federal Reserve. Because that money sits on deposit, the banks don't earn interest on the money. If the bank runs low on reserve requirements, it will borrow the money from another bank that has plenty of money to lend. When they borrow money, the lending bank will charge a rate of interest called the federal funds rate. As of September 2009, the rate is 0.25 percent. This money is normally borrowed overnight.
  
  

Economic Activity

• The Federal Reserve can influence economic activity by adjusting the reserve requirement of banks. If the Fed increases the reserve requirement, banks will have less money to lend to consumers and this will slow down economic activity. When consumers are not permitted to borrow, they will spend less. Decreasing reserve requirements has the opposite effect.
  
  

Discount Rate

• A bank can also choose to borrow money directly from the Federal Reserve at the discount rate. This rate will be a little more than the federal funds rate and it's determined by the board of governors at each reserve bank. Adjusting the discount rate can also influence different variables with the economy. This is another tool to influence economic activity.
  
  

Purpose

• The reserve requirements that banks have on deposit are to be used during tough economic times when they are most likely to encounter an abundance of losses. The percentage of deposits used as reserve requirements is 10 percent. Banks use these reserve requirements as a matter of liquidity and to help improve their overall financial situation.
  
  

Federal Funds Rate

• The Federal Reserve has the ability to influence a number of economic factors, including inflation, interest rates and the money supply, by using the federal funds rate. If the Fed wants to decrease interest rates, they can decrease the federal funds rate, which has the tendency to increase economic activity. However, if too much borrowing take place, inflation can increase to an unacceptable level. which will spur changes in the federal funds rate.