Saturday, November 20, 2010

The Reserve Requirement is in the news! The Reserve Requirement is in the news!

     Ok, not in the US, but in China. However, it is an important concept that applies to the US banking system, so here we go with a basic primer on it...
     One of the monetary policy tools the U.S. Federal Reserve has at its disposal to control the amount of money commercial banks can loan out is called the "Reserve Requirement Ratio". The Reserve Requirement Ratio (aka "RRR") is set by the Federal Reserve. When a bank receives a deposit, it is required to with-hold a percentage of that deposit in its Required Reserves account with the Federal Reserve. The rest of the deposit not subjected to the reserve requirement is then put in the banks "excess reserves" account and may be lent out by the bank in the form of a loan to a customer.
     Here is a simple example:  I deposit $1,000 into my checking account (aka "Demand Deposit" in banking parlance). Assume the Federal Reserve sets the RRR at 10%. The bank is required to with-hold $100 of my deposit in its Required Reserves account with the Federal Reserve and can deposit up to $900 in its "excess reserves" account. MY bank can then loan out up to $900 to a customer, who in turn, it is assumed, will purchase some new (or perhaps used) good and/or service with that money, hence increasing GDP.
     If the Federal Reserve wanted to INCREASE the amount of excess reserves my bank could loan out, then it would DECREASE the RRR.  If the RRR was lowered to 5%, then my bank would have to with-hold only $50 from the $1000 deposit and loan out $950, a larger amount than before. The assumption is that a borrower could now purchase $50 MORE in "stuff" than before the change in the RRR, hence a larger increase in GDP.  The Federal Reserve might employ this monetary policy tool if the economy were at less than full-employment or recession.  More excess reserves =more loans =lower interest rate on those loans= more purchase of GDP = increase in Aggregate Demand = closer to full-employment. 
    What works forward, also works in reverse. If the Federal Reserve wanted to DECREASE the amount of excess reserve my bank could loan out, it would INCREASE the RRR. If the RRR is increased to 20%, then my bank is required to with-hold $200 of the $1,000 demand deposit and can loan out, in excess reserves, a maximum of $800, which is $100 less than if the RRR were 10%.  Now LESS money is available to be loaned out and presumably LESS "stuff" will be purchased, hence GDP would decrease.  The Federal Reserve might employ this monetary policy tool if the economy were experiencing inflation.  Less excess reserves = fewer loans = higher interest rates on those loans = less purchase of GDP = decrease in Aggregate Demand = closer to full-employment (reducing price level/inflation). 
   I used the example of only one bank when the Federal Reserve utilizes the monetary policy tool of changing the RRR,  but it applies to all banks.  In general, what happens at one bank will happen at all banks (in a follow-up blog entry I will change this assumption).  So, if the Federal Reserve decreases the RRR all banks will be able to loan out more in excess reserves, which will tend to decrease interest rates as more excess reserves become available to be loaned out, which tends increase the number of loans, which tends to increase the purchase of consumer goods ("C") or investment goods ("I") which tends to increase GDP. I will ignore the effect this has on Net Exports in this example, but suffice it to say, it will also serve to increase GDP.  This will help solve recession.  I believe you can now follow the logic of what an increase in the RRR will have on the banking system to solve the problem of inflation. 
     All countries have some semblance of a Central Bank (we call ours "The Federal Reserve Bank of the US").  The Chinese Central Bank just increased its RRR for banks in China, so they have some concerns about inflation and are trying to reign in excess reserves.  Click HERE to read all about it. 
     It is a great time to teach an introductory college level class---MOST of textbook stuff is coming alive in the "real-world"! It is sad to say, but the crappy economy makes it easier to teach economics! (Should I have said that out loud???)
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