Who can raise the required reserve ratio? How does raising the required reserve ratio lead to a reduction in the money supply?
do a little research then take a shot. Hint: find "money multiplier" on the web or in your text.
The required reserve ratio is a tool implemented by central banks, such as the Federal Reserve in the United States, to regulate the money supply in an economy. The central bank has the authority to raise or lower the required reserve ratio.
When the required reserve ratio is raised, it means that banks are obliged to hold a higher portion of their deposits as reserves, rather than lending them out. This reduction in the amount of money banks can lend leads to a decrease in the money supply.
To understand how raising the required reserve ratio affects the money supply, we can look at the concept of the money multiplier. The money multiplier is the ratio of the amount of money created by the banking system to the initial amount of reserves injected into the system. It indicates how much the money supply expands based on changes in the reserve requirement.
To calculate the money multiplier, you can use the following formula:
Money Multiplier = 1 / Reserve Ratio
So, if the reserve ratio is increased, the money multiplier decreases. This reduction in the money multiplier means that banks cannot create as much additional money through the lending process, resulting in a decrease in the money supply.
To further illustrate this, let's consider an example. Suppose the reserve ratio is initially 10%, and the central bank decides to raise it to 20%. Prior to the increase, if a bank receives a deposit of $100, it can keep $10 as reserves and lend out $90. This $90 can then be deposited in another bank, which can keep $9 as reserves and lend out $81. This process continues, with each bank maintaining reserves and lending out a smaller portion of the deposit.
However, if the reserve ratio is increased to 20%, the initial deposit of $100 would require the bank to keep $20 as reserves, leaving only $80 available for lending. This reduction in lending capability continues throughout the banking system, resulting in a smaller expansion of the money supply.
In summary, raising the required reserve ratio decreases the amount banks can lend, which in turn reduces the money supply. This relationship is explained by the money multiplier concept, where an increase in the reserve ratio leads to a decrease in the money multiplier and a subsequent contraction of the money supply.