Question

Suppose that the Central Bank decided to increase percent of Reserve Requirement Ratio (RRR) from 10% to 15% to solve inflation problem. With the aid of money market diagram, explain the impact of an increase in RRR to the money market equilibrium.

Answer 1

Reserve requirement ratio( RRR ) is the Legal reserve ratio which is mandatory for every bank to adhere to when they give out loans and other borrowings. This ratio is of two types; Cash reserve ratio and Statutory liquidity ratio which controls and  distributes the proportion of deposits to be kept with the central bank and with the commercial bank respectively.

In times of inflation, Central Banks increase this ratio to control and contract credit. Let us see a diagram.

When the central bank raises RRR, commercial banks are forced to keep more funds in their reserves at the central bank and with themselves. This reduces the funds available to be given out as loans. Money supply in a given day is fixed and constant, and when the Central Bank raises RRR, Money supply curve shifts leftward, indicating lesser quantity of credit and money supplied into the economy and an increase in the nominal rate of interest as a result of tight credit availability. Thus with an increase in RRR from 10% to 15%, the equilibrium point shifts from E to F to money supply quantity and rate of interest QS1 and R1 respectively, indicating higher nominal rate of interest and lesser money supplied in the economy.