Question

Explain why is it that when the Central Bank of the Republic of China (CBC) decreases the required reserve ratio, the monetary base does not change. Will changing the currency drain ratio have the same effect? Explain what happens to the monetary base and the quantity of money when the CBC increases the discount rate and sells government securities.

Answer 1

Generally when a central bank decreases the required reserve ratio, the banks have more money to lend to the consumers and businesses. Such a measure by a central bank is called pursuing expansionary monetary policy usually to maintain higher economic growth.

But if the Central Bank of the Republic of China (CBC) decreases the required reserve ratio, the monetary base does not change. It could only happen if the Central Bank along with this move also pursues a different move that may require the banks to use their money to purchase government securities such as treasury bonds.

Currency drain ratio is the ratio of currency “leaked” from the banking system (Desired Currency Holdings) to deposits held by banks.

Currency drain ratio = currency / deposits currency.

As we can see above change in currency drain ratio will impact the monetary base of the banks.

When the CBC increases the discount rate and sells government securities more and more money of the banks flows back to the central bank and thus monetary base decreases.