Reserve requirement is part of deposits that commercial banks must hold as reserves. Banks cannot use it to make loans.
The central bank usually sets reserve requirements as a percentage of total deposits, say, at 10%. That means if the total customer deposit of Rp100, the bank must keep Rp10 in reserve and can use Rp90 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
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.
How does the reserve requirement ratio work?
Let’s take a simple example. Because of the sluggish economy, the central bank adopts an expansionary monetary policy by reducing the reserve requirement ratio, say from 10% to 5%. The aim is to increase the money supply so that it stimulates aggregate demand and economic growth.
A decrease in the reserve ratio leaves the bank with more money to lend. Say, a bank gets a deposit of Rp100 from a customer. Now, with a lower reserve ratio, the bank saves Rp5 (5% x Rp100) as a reserve and can lend Rp95, more than before (Rp90).
Through the money creation process, money multiplies 20 times as it circulates in the economy and the banking system. That means each Rp100 money will produce an amount of Rp2,000 in circulation. We calculate the effect of the money multiplier using the following formula:
Money multiplier = 1 / Reserve requirements ratio
The lower the reserve ratio, the greater the money multiplier. Conversely, a high reserve ratio decreases the effect of a money multiplier.
Reserve requirements as instruments of monetary policy
If the central bank opts to reduce the reserve ratio through an expansionary monetary policy, commercial banks are required to save less cash. As holding lower reserves, banks have more money to make loans to consumers and businesses. As a result, economic liquidity increases, pushing interest rates down.
Lower interest rates make borrowing costs cheaper. More consumers and businesses access new loans to buy goods and services, increasing aggregate demand. Rising demand encourages firms to increase production. When the market grows stronger, they also begin to recruit more workers and raise selling prices to offset the increased production costs. As a result, the real GDP is growing, unemployment is decreasing, and inflationary pressures are beginning to rise.
Conversely, by increasing reserve requirements, the central bank reduces access to credit in the economy because bank loans are reduced. Liquidity is becoming tighter and pushing interest rates up.
An increase in interest rates reduces consumer and business demand for credit. They also begin to reduce the demand for goods and services that had been financed through loans. As a result, aggregate demand weakens, forcing businesses to rationalize production costs, either by reducing output or reducing labor. As a result, economic growth slows, unemployment begins to rise, and inflationary pressure eases.