Question

How does the reserve requirement tool affect the ability of deposit – type financial         institutions to create money?   What are the principal advantages and   disadvantage the reserve requirement tool?

Answer 1

The reserve requirement is also known as the cash reserve ratio.

Reserve requirements are the amount of funds that a bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdrawals.

Reserve requirements are a tool used by the Federal Reserve to increase or decrease the money supply in the economy and influence interest rates.

The reserve requirement is one tool central banks use to control the money supply. Higher reserve requirements mean less money loaned out and in circulation.

Higher reserve requirements perhaps reduce the risk of a bank failing, but they can slow and economy down by keeping money tied up instead of being out working.

Advantages of reserve requirements:

1. It affects all banks equally and has a powerful effect on the money supply.

2. It protects the banking industry from sudden cash shortfalls.

Disadvantages of reserve requirements:

1. Not practical because small changes in the required reserve ratio lead to large changes in the money supply.

2. Raising reserve requirements may cause liquidity problems for banks with low excess reserves.