We are used to hearing plenty of chatter surrounding interest rates: Will they be raised? Be lowered? But behind those interest rate decisions is another integral part of monetary policy: bank reserves.

Bank reserves are funds that big commercial banks hold in accounts at the Federal Reserve. They are a key tool in influencing interest rates. Banks use these reserves to settle payments with one another and manage day-to-day cash needs. Think of it simply as the bank account for your bank.

Most of us don’t care to think about how many reserves a bank holds at the Federal Reserve. But we do care about what happens to interest rates and inflation.

How much cash is available in this system matters because reserves help the Fed maintain control over short-term interest rates. And these short-term interest rates eventually influence the borrowing costs that consumers and businesses see by impacting rates on credit cards, business loans, lines of credit, and other borrowing costs.

To understand how cash reserves influence interest rates, it is helpful to look at three different reserve environments: abundant, ample, and scarce.

Abundant Reserves: More Than Enough

An abundant reserves environment is exactly what it sounds like: banks collectively have substantially more reserves than they need to comfortably operate.

Imagine a bank already has far more available cash than it needs. Receiving another dollar is not going to meaningfully change much. Likewise, losing a relatively small amount probably will not cause much concern. This is what makes reserves abundant.

Following the Fed’s large asset purchases during the pandemic (a tactic to keep the economy afloat amid the shutdowns), trillions of dollars of reserves entered the banking system. With such a large cushion of liquidity, banks had little need to compete with one another for additional reserves.

This is where the connection to interest rates comes in.

When reserves are abundant, adding or removing small amounts of reserves has almost no effect on the rate banks charge each other for overnight loans, also known as the Fed Funds Rate. There is already so much cash available that banks do not need to offer significantly higher rates to get more of it. This keeps that fed funds rate stable and close to the rate the Federal Reserve would like to see. But it is important to remember that when there is more money to go around, there is more room for prices to rise.

Ample Reserves: The Middle Ground

Over the past several years, the Fed has reduced the enormous amount of excess liquidity created during the pandemic, an attempt to cool inflation. As reserves declined, the banking system moved from an abundant reserves framework to an ample reserves framework.

Ample reserves represent the middle ground. Banks still have enough cash to comfortably meet their needs, but they are no longer sitting on the enormous cushion that existed when reserves were abundant.

Another thing to note is that ample is not a specific dollar amount, think of it as more of a range.

When reserves are ample, there is still plenty of cash available, but every dollar begins to matter a little bit more. Small changes in the number of reserves may cause some movement in short-term rates, but not enough to interfere with the Fed’s control over interest rates.

This is essentially the Fed’s desired middle ground. Enough liquidity to keep the financial system functioning smoothly and short-term interest rates under control, without maintaining much more reserves than the banks need that could ultimately cause other problems.

Scarce Reserves: Every Dollar Matters

If reserves were to fall below the ample range, the banking system would eventually become scarce.

The word “scarce” may sound alarming, but it doesn’t necessarily mean banks have run out of money. In fact, the United States operated with a scarce reserves framework before the 2008 financial crisis and it was not what led to the crisis.

Scarce simply means banks hold much smaller reserves relative to their liquidity needs.

With less cash sitting readily available at the Fed, banks must manage their reserves more carefully. A bank that needs additional reserves may need to borrow them from another institution.

And when more banks are competing for a smaller pool of available reserves, the price of borrowing that money, the interest rate, becomes much more sensitive to supply and demand.

Think of it this way: when reserves are abundant, another dollar barely matters.

When reserves are ample, another dollar matters somewhat, but banks still have plenty of available cash at their disposal.

When reserves are scarce, every dollar matters much more.

This is why relatively small changes in reserve supply can produce much larger movements in short-term interest rates when reserves are scarce.

Where Are We Now?

The Fed has spent the past few years reducing the size of its balance sheet and removing some of the excess liquidity that entered the financial system during and after the pandemic.

By late 2025, the Fed determined that reserves had moved from abundant into ample range and stopped shrinking its balance sheet. Today, the Fed’s stated goal is to maintain ample reserves, not intentionally push them into scarcity or bring them back up to abundance.

The aim is to not drain as much cash from the banking system as possible. Instead, the Fed is trying to find the appropriate balance.

So, What Does This Have to Do with Interest Rates?

The Federal Reserve sets a target range for the federal funds rate. One of the Fed’s main tools for keeping that rate where it wants is the interest rate it pays banks on their reserve balances, also known as the interest rate on reserve balances or IORB.

When reserves are ample, the Fed can change the rate it pays on reserves and influence other short-term rates without having to constantly add or remove cash from the banking system.

But if reserves became too scarce, supply and demand would begin playing a much larger role. Banks needing cash could bid interest rates higher, making it more difficult for the Fed to keep rates where they want. This is why the amount of reserves matters; they help create the environment in which the Fed’s interest rate policy can do what it’s supposed to.

Abundant reserves can put upward pressure on inflation since there is more money available in the financial system. More money moving through the economy can lead to higher spending and higher prices. Over the past several years, we have seen very high reserve levels alongside higher inflation, increased government spending, and growing debt. While abundant reserves are not the sole cause of all these problems, it is a good reminder that more is not always better. We are encouraged to see the Fed moving away from the extremely high reserve levels of recent years towards a more balanced approach.