Sunday, April 17, 2011

Perfect timing--We are covering Monetary Policy in AP Macro---China Raises it's Reserve Requirement...Why would they do this???

One of the Monetary Policy Tools Central Banks around the world have at their disposal to control the money supply in the banking system is the Reserve Requirement.  Banks are required to withhold a certain percentage of each deposit (the Required Reserve Ratio--"RRR") they receive in the form of Required Reserves held on account with the nation's Central Bank (the US Federal Reserve Bank, in the case of the US). The Central Bank can either increase or decrease the RRR.  This will have an impact on the amount of excess reserves available to be lent out to customers.

China' Central Bank is employing this particular monetary policy tool to address accelerating inflation in their economy.

From BBC: China raises bank reserves for fourth time this year

By insisting banks hold more cash, the central bank hopes to restrict lending, which in turn will reduce spending.

The latest move, raising the required reserve ratio from 20% to a record 20.5%, is expected to lock up about 350bn yuan ($54bn; £33bn) that banks would otherwise be able to lend.

Inflation in China hit 5.4% in March.

Rising food prices have been the main cause, with the cost of food up 11.7% in the year to March. Housing costs have also risen sharply.

The central bank has also raised interest rates four times since October as it tries to curb inflation.
Here is a simple example: If the Required Reserve Ratio is 10% and a bank recieves a $1,000 deposit the bank must withold $100 in an account with the Central Bank. The bank can then loan the remaining $900 (called "Excess Reserves") to customers to buy "stuff".If the Central Bank wants to slow down lending, hence the purchasing of "stuff", then they RAISE the RRR so banks withhold more and have less to lend out in excess reserves.  Assume the Central Bank raised the RRR to 20%.  Now, if a bank receives a $1,000 deposit they must withhold $200 and the maximum it can loan out from this deposit is $800.  The banking system has fewer Excess Reserves to lend out. This tends to INCREASE the interest rate at which money is loaned out.

The Central Bank raises the RRR in times of inflation, or if they anticipate inflation, to put a damper on borrowing for consumer/business purchasing and asset speculation by investors. It is meant to slow down or reverse the Aggregate Demand for goods/services.

This is a key concept on the AP Macroeconomics test...A must know!!!
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