The reserve ratio is the amount of reserves, or cash deposits, that a bank must keep and not lend. The higher the reserve requirement, the less money a bank can lend, but this excess cash also prevents a bank failure and underpins its balance sheet. Even so, when the reserve ratio increases, it is considered a contractionary monetary policy, and when it decreases, expansionary.
If the Federal Reserve decides to reduce the reserve ratio through expansionary monetary policy, commercial banks must have less cash on hand and can increase the amount of loans to make to consumers and businesses. This increases the money supply, economic growth, and the rate of inflation.
- The reserve ratio is the central bank’s mandate for banks to maintain certain reserve requirements, which are excess cash deposits that must be kept on hand and not borrowed.
- Raising the index is contractionary as fewer loans can be made, but this also solidifies bank balance sheets.
- If, instead, the Federal Reserve reduces the reserve ratio through expansionary monetary policy, commercial banks must have less cash on hand and can make more loans.
What is the monetary policy of the Federal Reserve?
The Federal Reserve’s monetary policy is one of the ways the United States government attempts to regulate the nation’s economy by controlling the money supply. You need to balance economic growth with rising inflation. If you adopt an expansionary monetary policy, you increase economic growth but also accelerate the rate of inflation. If you adopt a contractionary monetary policy, you seek to reduce inflation but also inhibit growth.
The three ways the Federal Reserve achieves 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 that banks must hold in cash. These banks can keep the cash on hand in a vault or leave it at a local Federal Reserve bank. The exact reserve ratio depends on the size of a bank’s assets. The reserve ratio is calculated as:
Reserve ratio = Reserve requirements (in dollars) / Deposits (in dollars)
When the Federal Reserve lowers the reserve ratio, it reduces the amount of cash banks must 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 increased spending activity can also work to increase inflation.
As a simplistic example, suppose that the Federal Reserve determined that the reserve ratio is 11%. This means that if a bank has deposits of $ 1 billion, it must have $ 110 million in reserve ($ 1 billion x .11 = $ 110 million) and could therefore make loans totaling $ 890 million. .
Now suppose the central bank wants to make its monetary policy somewhat more expansionary and encourage more loans to stimulate economic activity. To do this, reduce the reserve ratio to 10%. Now the bank with $ 1 billion in deposits must save $ 100 million and can lend $ 900 million (instead of $ 890 million).