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.
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