China Cuts "Required Reserve Ratio" to stimulate lending and Investment. What does that mean exactly?

One of the tools modern Central Banks around the world have to affect money supply, hence interest rates that money is saved or borrow at, is the "Required Reserve Ratio (RRR)".

To prevent banks from lending out (or otherwise use) all of a deposit made by a customer they are required to with-hold a certain  percentage of that deposit in an account with the Central Bank.  After they with-hold the required amount banks put the remaining balance in their "Excess Reserve" accounts from which they can make loans.

China’s largest banks are currently required to hold 20 per cent of deposits as reserves at the central bank, while medium-sized lenders must meet ratios of 18 per cent. Rural banks and other small lenders are subject to a rate of 16.5 per cent or less. (Source: Financial Times)

Simple example: I make a $100.00 cash deposit in my bank. If the RRR is 20% then the bank puts $20.00 of that in their Required Reserve account and $80.00 in Excess Reserves.  The bank may loan up to $80.00 to a borrower.

At least that is the story that is told.  For now, we will go with it since it is a BIG part of the AP Macroeconomics curriculum.

You can see the constraint on lending in this scenario is the RRR.  If the RRR is LOWERED than banks are required to with-hold LESS of a deposit and the Excess Reserves to be loaned out are HIGHER. Banks tend to make more loans.  More loans are made to businesses for projects and/or capital equipment purchases. Economy boosted. Key vocab term for AP--"Expansionary or Loose Monetary Policy" designed to stimulate Aggregate Demand ("Investment" (I) in C+I+G +N):

Zhang Zhiwei, China economist at Nomura, described the move as “significant”. By his calculations, the new cut will inject about Rmb95bn ($15bn) back into the banking system. When added to other measures, such as the April cut, Beijing will have added Rmb545bn of fresh liquidity into the economy by the end of this month, equivalent to a 50 basis point cut to reserve requirements for all banks.

China has taken a fresh step to boost flagging growth by cutting the amount of cash reserves some lenders must hold at the central bank in a bid to boost lending to small businesses and the rural economy. 

The People’s Bank of China said it would reduce the “required reserve ratio” by 0.5 per cent for banks that mainly lend to small businesses and rural borrowers.(Source: Financial Times)

 At least that is the story that is told. For now, we will go with it since...

Nice Article on the Federal Reserve Bond Buyers...Learned some things I did not know...A must read for an AP Macro Class or a Money and Banking Class in College.

NYTIMES: The Fed’s QE2 Traders, Buying Bonds by the Billions

The smallest miscalculation, a few one-hundredths of a percentage point here or there, could unsettle the markets and cost taxpayers dearly. It could also embolden critics at home and abroad who say QE2 represents a dangerous expansion of the Fed’s role in the markets.

In a spare, government-issue office in Lower Manhattan, behind a bank of cubicles and a scruffy copy machine, Josh Frost and a band of market specialists are making the Fed’s ultimate Wall Street trade. They are buying hundreds of billions of dollars of United States Treasury securities on the open market in a controversial attempt to keep interest rates low and, in the process, revive the economy.

To critics, it is a Hail Mary play — an admission that the economy’s persistent weakness has all but exhausted the central bank’s powers and tested the limits of its policy making. Around the world, some warn the unusual strategy will weaken the dollar and lead to crippling inflation.


But inside the Operations Room, on the ninth floor of the New York Fed’s fortresslike headquarters, there is no time for second-guessing. Here the second round of what is known as quantitative easing — QE2, as it is called on Wall Street — is being put into practice almost daily by the central bank’s powerful New York arm.

Each morning Mr. Frost and his team face a formidable task: they must try to buy Treasuries at the best possible price from the savviest bond traders in the business.

Validation of my rant in class about the Fed-to-Banks-to-US Treasury circular flow of money/circular flow of logic that reminds me of a hamster on a treadmill...

Last class period I explained one of the pieces of the puzzle as to why the banking system is not lending as much money as they could be. even though the Federal Reserve is/has been on a bond buying spree.  The short version---(1) Federal Reserve BUYS a $1,000 bond  from a bank--(2) Bank withholds more than is required (or another way of saying this, is they lend out less than they are able to) because they believe  it is too risky to lend to people/businesses right now--(3) Bank buys US Treasury Bonds/Notes as a way to earn interest on the money...Repeat steps 1 through 3...Some lending is occurring, but not on the level required to get the economy going.  Just so you can see that I am not making this up because it sounds so preposterous, here is a comment from today's NYTIMES:

""Here’s the way things are supposed to work and normally do: Banks take in deposits and then lend that money out.


And here’s what’s happening more frequently now: People are doing a better job of spending less than they earn, but any leftover money is going toward paying down debt, not taking on new debt.


So to the extent that banks have deposits, they can’t lend them out in the quantity they used to (or aren’t because of tightened credit policies). Instead, they buy Treasury bills, according to Bill Hampel, the chief economist for the Credit Union National Association. And those don’t pay as they once did because of the interest rate environment. Nor do they deliver the kind of returns the banks would get if they were lending the money under normal conditions. ""

Low returns from US Treasurys are, at best, better than taking chances with credit risks and, at worst, better than a sharp stick in the eye.  I suppose it falls somewhere inbetween...

The Reserve Requirement in action!! Hey, it is as rare as Haley's Comet...Let me enjoy the spectacle that is a Monetary Policy tool rarely employed by a Central Bank...

The reserve requirement is the Monetary Policy tool of last resort for the US Federal Reserve to employ to control the money creation process in the banking system, but it is used by other Central Banks around the world on occassion.  Click HERE for more detailed explanation of the Reserve Requirement and click HERE for my explanation of the Required Reserve and how it affects lending by the banking system.

From WSJ: Brazil Joins China in Push to Cool Overheating Economy

""Brazil's central bank rolled out a series of measures to tame rapid credit growth and prevent inflation pressures, joining other large expanding economies such as China that are trying to curb rising prices and fast moving capital inflows.

Brazil's Central Bank President Henrique Meirelles said the directives announced Friday, which aim to withdraw some 61 billion Brazilian reais ($35.88 billion) from the financial system, will have an impact on inflation and economic activity, and would also be felt in interest rates.


The Central Bank said it would raise reserve requirements on term deposits to 20% from 15%...

 "As we have seen during the past year, central banks have often been using reserve requirements as the first step down the tightening path, and such hikes have almost universally been followed by policy rate hikes as well,." said Win Thin, Global Head Of Emerging Markets Strategy at Brown Brothers Harriman in New York.""

Need money for College? The Dallas Federal Reserve Bank Essay contest may be for you!

This is a great opportunity for you if you like to write and are at least a little bit interested in economics. You don't need alot of economic knowledge for this contest, but it helps! Check out the topic.  It is an easy one this year...From what I gather, they don't get alot of entries so you have a better than average chance of winning...Go to the essay contest webpage HERE for more details...I will be happy to assist you in getting started with your essay...

21st Annual Essay Contest 2011

Topic: Consume or Conserve?

Essay contest deadline: March 11, 2011

One of the basic questions of economics is the choice between consumption and saving. When scarce resources are used today, what is the impact? Will future generations lack important resources because they have been depleted? Can the use of some types of resources cause irreparable harm to the environment?

A variety of public and private initiatives seek to encourage consumers to conserve natural resources in order to slow resource depletion or minimize environmental impact.

Curbside recycling in a city

Land that is set aside through private or public initiatives

Mandatory fuel standards or tax credits for hybrid vehicles

Carbon taxes or cap and trade systems

Green building codes

The 2011 Economic Essay Contest, Consume or Conserve?, asks you to judge one of these conservation initiatives or one of your own choosing. Use basic economic concepts, such as scarcity and opportunity costs, and fundamental economic models, like supply and demand, to analyze the merits and effectiveness of a specific conservation plan or environmental regulation. The initiative that you analyze might be local, national or global in scope. In your essay, describe the plan and its benefits, evaluate the costs of the plan and draw a conclusion about the effort.

Contest Details

The contest is open to 11th and 12th grade students attending schools in the Eleventh Federal Reserve District, which covers Texas, northern Louisiana and southern New Mexico. Participants submit essays to the appropriate office of the Dallas Fed, as determined by the location of their school. See the list of Eleventh District counties to determine the appropriate office.

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???)