Question

Describe the importance of commercial banks’ reserve ratio. Give concrete examples.

Answer 1

ANS

The reserve ratio of commercial banks is the ratio which determines the amount which is to be kept with the bank for the situation of withdrawl of the customers,this ratio is determined by the federal banks and the amount which is remaining from the amount of reserve ratio is used for granting loans. This is the way the bank generates income and profits, the lower the reserve ratio will be the higher will be the profits of the banks as the interest charged from the loan is much higher from the interest which is offered for the deposits. The reserve ratio also gives an impact on the inflation as the lower reserve ratio generates greater money supply and more money supply creates inflation . The other importance could be in the situation when the government has to lower the inflationary rate and it is done by increasing rate by increasing the reserve ratio. For ex Suppose the reserve ratio is 10% and the funds in the bank is 10000 dollars, the interest offered on the funds or deposists is 4% and interest asked on loans is 10%. Since the reserve ratio is 10% then the bank grants the loan of 9000 which provides the interest of 900 and the interest on deposits given to customer is 400. So the total earning of bank is 900 - 400 = 500 dollars. In case where government has to increase the money supply then it lowers the reserve ratio and vice versa.