The reserve ratio is the amount of reserves—or cash deposits—that a bank must hold on to and not lend out. The greater the reserve requirement, the less money that a bank can potentially lend—but this excess cash also staves off a banking failure and shores up its balance sheet. Still, when the reserve ratio increases, it is considered contractionary monetary policy, and when it decreases, expansionary.
If the Federal Reserve decides to lower the reserve ratio through an expansionary monetary policy, commercial banks are required to keep less cash on hand and are able to increase the number of loans to give consumers and businesses. This increases the money supply, economic growth and the rate of inflation.
Key Takeaways
- The reserve ratio is the central bank's mandate for banks to keep a certain reserve requirements, which are excess cash deposits that must be kept on hand and not loaned out.
- Raising the ratio is contractionary since less loans can be made, but this also solidifies banks' balance sheets.
- If the Federal Reserve instead lowers the reserve ratio through an expansionary monetary policy, commercial banks are required to hold less cash on hand and can make more loans.
What Is the Federal Reserve's Monetary Policy?
The Federal Reserve's monetary policy is one of the ways in which the U.S. government tries to regulate the nation's economy by controlling the money supply. It needs to balance economic growth with increasing inflation. If it adopts an expansionary monetary policy, it increases economic growth but also accelerates the rate of inflation. If it adopts a contractionary monetary policy, it seeks to reduces inflation but also inhibits growth.
The three ways in which the Federal Reserve achieves an expansionary or contractionary monetary policy include the use of the following:
How Does the Reserve Ratio Affect the Economy?
The reserve ratio dictates the reserve amounts required to be held in cash by banks. These banks can either keep the cash on hand in a vault or leave it with a local Federal Reserve bank. The exact reserve ratio depends on the size of a bank's assets. The reserve ratio is calculated as:
ReserveRatio = ReserveRequirements (in dollars) / Deposits (in dollars)
When the Federal Reserve decreases the reserve ratio, it lowers the amount of cash that banks are required to hold in reserves, allowing them to make more loans to consumers and businesses. This increases the nation's money supply and expands the economy. But the increased spending activity canalso work to increase inflation.
Example
As a simplistic example, assume the Federal Reserve determined the reserve ratio to be 11%. This means if a bank has deposits of $1 billion, it is required to have $110 million on reserve ($1 billion x .11 = $110 million), and could therefore make loans totaling $890 million.
Now, assume the central bank wants to make its monetary policy somewhat more expansionary, and encourage more lending to spur economic activity. To do so, it lowers the reserve ratio to 10%. Now the bank with $1 billion in deposits is required to save $100 million and can lend $900 million (as opposed to $890 million).
FAQs
If the Federal Reserve decides to lower the reserve ratio through an expansionary monetary policy, commercial banks are required to keep less cash on hand and are able to increase the number of loans to give consumers and businesses. This increases the money supply, economic growth and the rate of inflation.
What happens when the required reserve ratio decreases? ›
A decrease in the reserve ratio will increase the size of the monetary multiplier and increase the excess reserves held by commercial banks, thus causing the money supply to increase.
What are the effects when the Fed decreases the reserve ratio quizlet? ›
If the Fed decreases the reserve ratio, the simple deposit multiplier will be larger, thereby enabling banks to expand the money supply by a greater amount.
What happens when you lower the reserve requirement? ›
A lower reserve requirement means the Federal Reserve is pursuing an expansionary monetary policy. The lower reserve requirement means banks do not need to keep as much cash on hand. This gives them more money for consumer and business loans.
What happens when Cash Reserve Ratio decreases? ›
Effect of Decrease in Cash Reserve Ratio
Effect on inflation: When the cash reserve ratio is minimised, commercial banks will have more funds and hence, the money supply of the banking system will increase. When there is a rise in the money supply, excessive funds will result in high inflation.
What does a low reserve ratio mean? ›
A lower reserve ratio requirement gives banks more money to lend, at lower interest rates, which makes borrowing more attractive to customers. Conversely, the Fed increases the reserve ratio requirement to reduce the amount of funds banks have to lend.
What happens if the Fed lowers the reserve requirement than this? ›
If the Fed lowers the reserve requirement, then this increases excess reserves, encourages banks to make more loans, and increases the money supply. decreases excess reserves, causes banks to reduce their loans, and decreases the money supply.
What could happen if the Federal Reserve lowered interest rates? ›
The Fed lowers interest rates in order to stimulate economic growth, as lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and subsequent inflation, reducing purchasing power and undermining the sustainability of the economic expansion.
How does the Fed decrease reserves? ›
When the Fed sells Treasuries, the process works in reverse, and bank reserves decline. Increases in the supply of reserves tend to push down the fed funds rate (the price of reserves) and other interest rates, while decreases in the supply of reserves raise interest rates.
What happens if the reserve requirements are decreased the reserve ratio? ›
Other things the same, if reserve requirements are decreased, the reserve ratio increases, the money multiplier increases, and the money supply increases.
Decreasing the ratios leaves depositories initially with excess reserves, which can induce an expansion of bank credit and deposit levels and a decline in interest rates.
What does a decrease in reserve requirements will definitely cause? ›
A decrease in reserve requirements will definitely cause: Excess reserves to increase. Sustained open market buying by the Fed will cause: depository institutions to lend more freely.
What happens if the required reserve ratio decreases from 20 to 10? ›
Answer and Explanation: A reduction in the required reserve ratio from 20% to 10% is an expansionary monetary policy because it implies that the banks are required to keep a lower proportion of the total deposits in the form of reserves, freeing up money to be given out as loans for credit creation.
What will happen to the credit creation if the Cash Reserve Ratio is reduced? ›
If RBI reduces the cash reserve ratio, credit creation will increase. Banks have more money at their disposal when the CRR requirement is reduced, which can subsequently be utilized to create credit in the economy. When determining the base rate, one of the reference rates is the Cash Reserve Ratio.
How does a decrease in the reserve ratio by the Federal Reserve affect the money supply and the interest rate quizlet? ›
A decrease in the Monetary Base by The Fed will trigger the money DESTRUCTION process and cause the Money Supply to DECREASE which will lead to AN INCREASE in the Interest Rate.
What happens when required reserves increase? ›
As discussed by Barro, an increase in the required reserve ratio operates like a tax on this intermediary activity, as banks are required to hold more reserves and thus make fewer loars.
