What is the ‘reserve ratio’? What changes do you observe during expansionary and contractionary monetary policies?

Reserve ratio is the percentage of cash or other liquid assets that commercial banks must have on hand. Guell (2015), in their book Issues in Economics Today, it is the fraction of deposits that regulators require a bank to hold in reserves and not to loan out. The board of Governors of the Federal Reserve System is normally in charge of determining this mandatory requirement. It is a tool for monetary policy which invariably influences the nation’s borrowing (loanable amount) and interest rates. The major purpose of such ratio is that it makes sure that commercial banks do not run out of money while meeting the demand for withdrawals.

Expansionary monetary policies

When the central bank decreases the reserve ratio than the supply capacity of banks increases as they would be having excess loanable funds; this increases the lending capacity of banks and can sufficiently meet the demand of the borrowers. The people will more opt for such situation as they can get a loan at the lower interest rate.

This actions of the central bank has the positive impact on the economy as the supply curve shift to the rightwards, the interest rate decreases and loanable funds increases which means that it boosts the economic activity as adequate liquidity is available in the financial system. Lower the reserve requirement higher the profits for banks as they have sufficient money to circulate in the economy. Thus, this economic process is known as an expansionary monetary.

Figure a: Expansionary monetary policies

Such monetary policy has a positive impact on the economy of the nation as it increases the aggregate demand of the nation which as a consequence increases the real gross domestic product (RGDP). Now the people would be having enough money to initiate their business due to adequate availability of loanable funds. Thus, this activates the economic activity of the country as the borrower would invest the loaned amount on production and manufacturing of products and services.

Contractionary monetary policies

The graph is plotted on the basis of inflation and its impact on the loanable funds and interest rate. When the inflation prevails in an economy the general price levels of the products and services get hiked up. So in order to control it, Federal Reserve or central banks of the country increase the reserve ratio. What does this policy do is that it shifts the supply of loanable funds towards the origin (or left) resulting in the decrease of loanable funds and increase in interest rate to the general public? As a consequence, the demand for loan decreases due to high-interest rate and people normally does not prefer higher interest on their borrowing as they have to pay more in return for the loanable amount (Amadeo, 2018). This strategy employed by the federal bank or central bank is known as the contractionary monetary policy. Ultimately the increase in reserve ratio reduces the liquidity and slows down the economic activity of the country which has been suffering from the inflation.

Figure b: Contractionary monetary policies

In addition, the contractionary monetary policy has affected the real GDP as it decreased from r to r1. The increase in reserve ratio has impacted the overall real GDP of the economy mainly due to less availability of loanable funds. This means that people could not borrow sufficient money from the banks to invest in business and production activities. Thus, this slowed down the economic activity of the nation resulting in the decrease in real GDP.

References

Amadeo, K. (2018). Reserve requirement and how it affects interest rates . Retrieved from thebalance.com/reserve-requirement... 4

Guell, Robert C. (2015). Issues in Economics Today , 7th edition- 2015 ISBN: 978-0078021817

Reserve ratio or cash reserve ratio (CRR) is the proportion of customers’ deposit that commercial banks are required to keep as cash according to the direction and regulation of central bank. The reserve ratio is set by a central bank for the safety of the nation’s financial institution. The reserve ratio of central bank directly affects banks’ deposit intermediation and checks bank leverage (Chowdhury, 2014). It influences the money supply of an economy and is used as a monetary policy tool.

For example, let’s assume that one commercial bank ABC has $10 million in deposits. If the central bank reserve ratio requirement is 10% then Bank ABC must keep at least $1 million in an account at a central bank as a reserve (see figure 1).

Figure 1: Reserve ratio

Reserve ratio

The central bank of a nation can adopt an expansionary or contractionary monetary policy tools to increase or decrease the money supply in a country.

An expansionary monetary policy focuses on increasing the money supply in an economy which lowers the interest rate. The lower interest rate reduces the cost of borrowing and the return to saving which leads to higher levels of capital investment by firms and households. Furthermore, an expansionary monetary policy will, by lowering the domestic interest rate, put downward pressure on the exchange rate (McDonald, 1993).

As shown in figure 2, when the central bank increases the money supply, it lowers the interest rate and increases the quantity demanded of goods and services at each and every price level. If a central bank is combatting a recessionary gap then it can increase the money supply which leads to a change in aggregate demand from AD1 to AD2. This results in greater Real GDP of a higher price level (See figure 2).

Figure 2: Expansionary monetary policy

Expansionary monetary policy

In another hand, Contractionary monetary policy focuses on decreasing the money supply in the economy. If the economy faces an inflationary gap then central bank engage in contractionary monetary policy. In order to compact inflation, the central bank decreases the money supply that causes interest rate to rise. The higher interest rate means that borrowing is more expensive and the return to saving is higher. In consequent, there is a decrease in AD due to contractionary monetary policy.

As shown in figure 3, there is an increase in interest rate and a decrease in the quantity of goods and services demanded at every price level when the central bank decreases the money supply. That is, the aggregate demand (AD) curve shifts leftward from AD1 to AD2. This results in lower Real GDP and lower price level at E2.

Figure 3: Contractionary monetary policy

Contractionary monetary policy

We can also exemplify and observe the changes of expansionary and contractionary monetary policy by the following figure. As shown in figure 4, the original equilibrium occurs at EO. An expansionary monetary policy will shift the supply of loanable fund to the right from the original supply curve (SO) to the new supply curve (S1) by lowering interest rate from 8% to 6 %. Similarly, a contractionary monetary policy will shift the supply of loanable fund to the left from the original supply curve (SO) to the new supply (S2) which raises the interest rate from 8% to 10 % (See figure 4).

Figure 4: Monetary Policy and Interest Rates

Monetary policy and Interest rate

References

Chowdhury, A. K. (2014). From Loan to Deposit: Deposit Creation by Banks and the Significance of Cash Reserves. Drishtikon : A Management Journal, 5 (2).

McDonald, I. M. (1993, Dec). Macroeconomic Policy For Recovery. The Economic and Labour Relations Review, 4 (2), 198-217.