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.
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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.