What is the difference between reserves and deposits?

The short answer

A reserve is a balance that a commercial bank holds at the central bank. It is a liability of the central bank and an asset of the commercial bank. Reserves are used to settle payments between banks and to meet regulatory requirements.

A deposit is a balance that a household or firm holds at a commercial bank. It is a liability of the commercial bank and an asset of the depositor. Deposits are the money that most people use.

They are both money-like, but they are issued by different institutions and used for different purposes.

Reserves are for settlement

When a customer of Bank A pays a customer of Bank B, the banks need to settle the claim. They do so in reserves. Bank A's reserve account at the central bank is debited, and Bank B's is credited.

Reserves are not generally available to households and firms. You cannot spend reserves at a shop. They are the wholesale settlement asset of the banking system.

Deposits are created by lending

When a bank makes a loan, it creates a deposit. The deposit is a liability of the bank. The bank does not need to transfer reserves to the borrower to create it. The borrower can spend the deposit, and the payment system will move reserves between banks as needed.^[1]

This is why the phrase "banks lend out reserves" is misleading. Banks lend by creating deposits. Reserves are the settlement balances that make the interbank payment system work.

What quantitative easing does

When the central bank buys a government bond from a non-bank investor, it credits the seller's bank with reserves. The seller's deposit increases, and the bank's reserves increase. The central bank's balance sheet expands.

QE therefore creates reserves directly and deposits indirectly, through the seller's bank. It does not hand cash to households, and it does not directly force banks to lend.^[2]

Why the distinction matters

Confusing reserves with deposits leads to bad conclusions:

• "Banks have trillions in reserves, so they can lend trillions." Not necessarily. Lending depends on demand, capital, and risk.
• "QE created trillions in deposits, so inflation must follow." The effect depends on spending, not just the accounting.
• "The Fed can control the money supply by controlling reserves." The modern framework is more indirect.

The bottom line

Reserves are the central bank's settlement money. Deposits are commercial-bank money. Both matter, but they are not the same thing.^[3]