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
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. 8.
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. 8.
What will happen to the money supply if the Fed decreases the reserve requirement responses? ›
When the Fed lowers the reserve requirement on deposits, the money supply increases. When the Fed raises the reserve requirement on deposits, the money supply decreases.
When the Federal Reserve decreases, the required reserve ratio quizlet? ›
First, the Federal Reserve decreases the required reserve ratio. Decreasing the required reserve ratio increases the amount of money banks can lend. The loans increase the money supply in the economy. The increased money supply leads to a fall in interest rates.
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 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.
What can happen to banks if the required reserve ratio is set too low? ›
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 does it mean if the Fed decreases reserve requirements? ›
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 would happen if the Federal Reserve System lowers the reserve requirement in Quizlet? ›
If the Fed lowers the reserve requirements what will happen? A portion of what was previously required reserves becomes excess reserves, which can be used to make loans and expand money supply. A lower reserve requirement also increases the deposit expansion multiplier.
What effect does a decrease in reserves have on the money supply quizlet? ›
A decrease in reserves decreases both M1 and M2. A decrease in reserves decreases the money supply through a multiplier process. What is something that the Federal Reserve does? The Federal Reserve issues U.S. currency.
The Fed typically cuts only when the economy appears to be weakening and needs help. Lower interest rates would reduce borrowing costs for homes, cars and other major purchases and probably fuel higher stock prices, all of which could help accelerate growth.
When the Fed lowers the reserve requirement then this? ›
increases excess. 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 happens if the Federal Reserve increases the reserve requirement? ›
. This is because an increase in the reserve requirement reduces the amount of money that banks have available to lend. As a result, banks will often lend less and keep more money on hand to meet the increased reserve requirement.
Which of the following will happen when the Federal Reserve lowers the interest rate paid on reserve balances? ›
Which of the following will happen when the Federal Reserve lowers the interest rate paid on reserve balances? Banks will choose to leave more of their money at the Fed overnight.
What is the impact of a decrease in the deposit ratio? ›
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 lowering the required reserve ratio do? ›
Lowering the reserve requirement pumps money into the economy by giving banks excess reserves, which promotes the expansion of bank credit and lowers rates.
What does a smaller required 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 when you lower the reserve requirement? ›
A smaller reserve requirement ensures a greater lending capacity of the banking system. The extent of money creation through checkable deposits via loans depends on the lending capacity of the banking system.An enormous lending capacity expands the money supply wider.
What happens if the required reserve ratio decreases from 20 to 10? ›
When the required reserve ratio decreases from 20% to 10%, it has multiple effects on the banking system and the money supply: A. Banks will have more money to loan out: With a lower required reserve ratio, banks are required to hold a smaller portion of their deposits as reserves.
