In: Economics
The reserve ratio is the portion of reservable liabilities that
commercial banks hold onto, rather than lend out or invest. This is
kept to meet out the withdrawal demands by customers for their time
deposits.The required reserve ratio is used as a tool in monetary
policy, influencing the country's borrowing and interest rates by
changing the amount of funds available for banks to loan out.
In this situation of crisis reserve requiremnet is 0 as government
wants to keep the money to lend out the money to people in need and
having a no reserve lowers down the interest rate. So it solves two
purposes, more amount to lend and a lower interest rate, thus
making money available to lmore people.
If after the crisis Reserve Requiremnt is increased to 10%, then
with a single dollar of invest ment huge returns can be brought
into the market which can be understood by the concept of money
multiplier. The multiplier is given by the formula (1/reserve
ratio), here it is 1/0.1 which equals 10.
So with this we see that with a $1 open market purchase, the final
amount in the market would end upto $10.
It can be understood as follows:
(assuming that the amount of open market purchase is invested by
people which is routed through banks, and banks again lend the
money out after keeping reserves and the cycle continues)
Amount | Investment | Reserves | Loaned Out |
1 | 1 | 0.1 | 0.9 |
0.9 | 0.9 | 0.09 | 0.81 |
0.81 | 0.81 | 0.081 | 0.729 |
0.729 | 0.729 | 0.0729 | 0.6561 |
0.6561 | .... | .... |
... |
.... | ..... | .... | .... |
10 | 10 | 1 | 9 |
The last row mentions the total of all the columns. And we see after the cycle ends up where there are no more money to be brought into the market, the total amount generated is 10 times the initial amount.