Question

Although the Bank of Canada doesn’t use changes in reserve requirements to manage the money supply, the central bank of Albernia does. The commercial banks of Albernia have $100 million in reserves and $1000 million in chequable deposits; the initial required reserve ratio is 10%. The commercial banks follow a policy of holding no excess reserves. The public holds no currency, only chequable deposits in the banking system.

a) How will the money supply change if the required reserve ratio falls to 5%?

b) How will the money supply change if the required reserve ratio rises to 25%?

Answer 1

Required reserves are a certain percentage of the deposits of the bank which it is required to keep with itself in the form of reserves. These reserves cannot be used by the bank for making loans and advances. The reserves which are over and above the required reserves known as excess reserves are used to extend loans and advances.

As, Initially the required reserve ratio is 10% , chequable deposits= $1000

Required reserves= deposits x required reserve ratio

Required reserve = $1000 million x 10%

Required reserves= $1000 million x 10/100

Required reserves= $1000 x 0.1

Required reserves= $100 million

Hence, commercial banks will keep required reserves of $100 million and lend out the excess.

The total amount of money supply can be calculated as-

New deposits= 1/RR x D

( Where RR is the required reserve ratio and D is change in Initial deposit)

New deposits= 1/10% x $1000 million

New deposits= 1/0.1 x $1000 million

New deposits= 10 x $1000 million

New deposits= $10,000 million

Hence, when the required reserve ratio is 10% , the money supply is $10,000 million.

a) If the required reserve ratio falls to 5% , then commercial banks will be required to keep less required reserves with themselves and they will be able to extend more loans. As such, the money supply will increase.

Required reserves= deposits x required reserve ratio

Required reserves= $1000 million x 5%

Required reserves= $1000 million x 5/100

Required reserves= $1000 million x 0.05

Required reserves= $50 million

Hence, the commercial banks will keep $50 as required reserves and will loan out the excess.

The total amount of money supply can be calculated as-

New deposits= 1/RR x D

New deposits= 1/5% x $1000 million

New deposits= 1/(5/100) x $1000 million

New deposits= 1/0.05 x $1000 million

New deposits= 20 x $1000

New deposits= $20,000 million

Hence, when the required reserve ratio is 5%, the money supply is $20,000 million.

From the above calculations we can see that when the required reserve ratio is 5%, money supply is more as compared to when the required reserve ratio was 10%. When required reserve ratio is 5% , money supply is $20,000 million and when required reserve ratio was 10% , money supply was $10,000 million . Hence, the change in money supply is-

change in money supply= $20,000 million -$10,000 million

change in money supply= $10,000 million

Hence , when the required reserve ratio is 5% , banks are required to keep less required reserves and are able to extend more loans and advances. Hence, money supply will change( increase) by $10,000 million when required reserve ratio falls from 10% to 5% .

b) . If required reserve ratio increases to 25%, banks will be required to keep more Required reserves and hence they will be able to extend less loans .

Required reserves= deposits x required reserve ratio

Required reserves= $1000 million x 25%

Required reserves= $1000 million x 25/100

Required reserves= $1000 million x 0.25

Required reserves= $250 million

Hence, commercial banks will keep $250 million as required reserves and will loan out the excess.

The total amount of money supply can be calculated as-

New deposits= 1/RR x D

New deposits= 1/25% x $1000 million

New deposits= 1/(25/100) x $1000 million

New deposits= 1/0.25 x $1000 million

New deposits= 4 x $1000 million

New deposits= $4000 million

Hence, when required reserve ratio is 25%, money supply is $4000 million.

From the above calculations we can see that when required reserve ratio is 25%, money supply is less as compared to money supply when required reserve ratio is 10%. Money supply is $10,000 million when required reserve ratio is 10% and money supply is $4000 million when required reserve ratio is 25% . Hence, the change in money supply is-

change in money supply= $10,000 million - $4000 million

change in money supply= $6000 million

Hence, when the required reserve ratio is 25% , commercial banks are required to keep more Required reserves with themselves and hence they are able to extend less loans and advances. The money supply will change( decrease) by $6000 million when required reserve ratio increases from 10% to 25% .