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Reserve requirement is a regulation that commercial banks must follow. It dictates a specific portion of customer deposits that banks are obligated to hold onto as reserves. These reserves cannot be used for lending and function as a safety net for several key purposes. Let’s dive deeper and explore how reserve requirements impact banks, the money supply, and, ultimately, the health of the economy.
What is the reserve requirement?
Reserve requirements are regulations imposed by central banks on commercial banks. They dictate a specific percentage of customer deposits that banks are legally obligated to hold onto as reserves. This essentially means that a portion of the money you deposit at your bank isn’t immediately available for them to lend out.
The central bank usually sets reserve requirements at 10% of total deposits. That means if the total customer deposit is $100, the bank must keep $10 in reserve and can use $90 to make a loan.
- Reserve requirements ratio = Reserve requirements / Total deposit
In addition to lending to non-bank debtors, banks that have excess reserves can lend to other banks that are deficient. The transaction takes place in the interbank market.
The purposes of the reserve requirement
The central bank sets reserve requirements to affect the growth of the money supply. The central bank uses reserve requirements as a monetary policy tool to control liquidity in the market.
When implementing expansionary monetary policy (to encourage economic growth), the central bank reduces the reserve requirement ratio. That way, the bank has more money to lend. Through the money multiplier effect, the amount of money multiplies in the economy.
In contrast, if central banks adopt a contractionary monetary policy, they raise the reserve ratio. Now, commercial banks have less money to lend. As a result, liquidity in the economy becomes tighter, pushing interest rates to rise. An increase in interest rates lowers aggregate demand and weakens inflationary pressures.
Why do banks keep money in reserve?
Commercial banks keep reserves not only to avoid defaulting on debts but also to make sure they have money when depositors withdraw cash. Thus, sufficient reserves are needed to meet these needs and maintain customer confidence.
When they don’t have enough money, they can have serious consequences. Not only does it cause the bank to fail, but it can also have a systemic impact on the banking system. That can trigger a bank run, in which many customers withdraw cash massively and suddenly because of the collapse of confidence in the banking system.
In essence, reserve requirement serves several crucial purposes:
- Maintaining liquidity: Banks need to have enough cash on hand to meet everyday customer withdrawals. Reserve requirements ensure that banks hold a buffer of funds to handle these withdrawals smoothly, preventing situations where they might not have enough cash to fulfill customer requests.
- Safeguarding the financial system: Reserves act as a safety net for the banking system. In case of unexpected surges in withdrawals, having a pool of readily available funds helps banks maintain stability and prevents bank runs – scenarios where a large number of depositors withdraw their money en masse due to fear of insolvency. This can have a cascading effect, crippling the entire financial system.
How reserve requirements affect money supply
Reserve requirements act as a lever for central banks to influence the money supply in the economy. Here’s how it works:
Expansionary monetary policy
When the central bank wants to stimulate economic growth, it might implement an expansionary monetary policy. One tool in their arsenal is lowering the reserve requirement ratio. This means banks are required to hold a smaller portion of deposits as reserves. Let’s see how this translates to increased lending:
Example: Imagine the reserve requirement is set at 10%. If a bank receives a deposit of $100, it must hold $10 (10% of $100) in reserve. This leaves $90 available for lending.
Now, if the central bank reduces the reserve ratio to 5%, the bank only needs to hold $5 (5% of $100) in reserve. This frees up an additional $5 (Rp90 – $85) for the bank to lend out.
This seemingly small change can have a significant impact on the money supply through a concept called the money multiplier.
Money multiplier
The money multiplier is a ratio calculated by dividing 1 by the reserve requirement ratio (Money Multiplier = 1 / Reserve Ratio). In our example, with a 5% reserve ratio, the money multiplier would be 20 (1 / 0.05).
Here’s how it amplifies the impact of a lower reserve ratio:
- The bank lends out the additional $5 it has available.
- The borrower uses this money to purchase goods or services.
- The recipient of that money (the seller) might deposit a portion of it in another bank.
- That bank, following the same reserve requirement, keeps a portion as reserves and lends out the remaining amount.
This cycle of lending and depositing repeats itself throughout the economy. With each iteration, the money supply expands as a multiple of the initial deposit, thanks to the money multiplier effect. A lower reserve ratio allows this cycle to multiply credit creation more aggressively, ultimately increasing the money supply in circulation.
Contractionary monetary policy
Conversely, when the central bank aims to cool down a hot economy and combat inflation, it might implement a contractionary monetary policy. One way to achieve this is by raising the reserve requirement ratio.
- Higher ratio, less lending: By requiring banks to hold a larger portion of deposits as reserves, less money is available for lending. This restricts the bank’s lending capacity, similar to the example above, with a lower ratio, but in reverse.
- Reduced money multiplier effect: A higher reserve ratio reduces the money multiplier. With less money circulating in the initial lending cycle, the overall expansion of the money supply is dampened. This tighter grip on credit availability helps to slow down economic activity and inflationary pressures.
In essence, reserve requirements are a tool that central banks use to manage the flow of credit and money in the economy. By adjusting the reserve ratio, they can influence how much banks lend, ultimately impacting economic growth and inflation.
The impact of reserve requirements on the economy
Reserve requirements don’t operate in isolation. They trigger a chain reaction that influences economic activity. Here’s a breakdown of how expansionary and contractionary policies implemented through reserve requirements impact the economy:
Expansionary monetary policy
Lower interest rates: When the central bank reduces the reserve ratio, banks have more money available to lend. This increased supply of loanable funds pushes interest rates down. Borrowing becomes cheaper, making loans more attractive for consumers and businesses.
Borrowing boom and spending spree: With lower interest rates, businesses are incentivized to take out loans to invest in expansion projects and equipment. Consumers, too, feel more comfortable taking on debt for cars, homes, or even everyday purchases. This surge in borrowing translates to increased spending across the economy.
Aggregate demand gets a boost: As businesses invest and consumers spend more, the total demand for goods and services in the economy, also known as aggregate demand, rises. This increased demand puts pressure on businesses to produce more.
Economic growth gains momentum: To meet the higher demand, businesses ramp up production, leading to economic growth. This growth is reflected in a rise in real GDP, which is the total value of goods and services produced in the economy adjusted for inflation. As production expands, businesses often need to hire more workers, leading to lower unemployment rates.
However, a potential downside of expansionary policy is the risk of inflation. With more money circulating in the economy due to increased lending and spending, competition for goods and services intensifies. This can lead to businesses raising prices to meet the higher demand, ultimately pushing inflation upwards.
Contractionary monetary policy
Higher interest rates: When the central bank raises the reserve ratio, it restricts the amount of money banks have available to lend. This limited supply drives interest rates upwards. Borrowing becomes more expensive, discouraging businesses and consumers from taking out loans.
Borrowing cools down, spending retrenches: With higher borrowing costs, businesses become more cautious about taking on debt for expansion. Consumers may also postpone big-ticket purchases or consolidate existing debt, leading to a decrease in overall spending.
Aggregate demand feels the pinch: As borrowing and spending weaken, the total demand for goods and services in the economy (aggregate demand) contracts. This puts downward pressure on prices as businesses face less demand for their products.
Taming inflation and slowing growth: Higher interest rates and weaker demand help to control inflation by making it more expensive to borrow and spend. However, this slowdown in economic activity can also lead to slower economic growth and potentially higher unemployment, as businesses may need to reduce their workforces in response to lower demand.
It’s important to note that the timing and intensity of these effects can vary depending on the specific economic circumstances. The effectiveness of reserve requirements also depends on factors like bank lending standards and the level of consumer and business confidence.
