Required Reserve Ratio
What is Required Reserve Ratio?
The required reserve ratio is the fraction of deposits that banks must hold in reserve rather than lend out.
Set by the central bank, a lower ratio lets banks lend more, increasing the money multiplier and the money supply. Raising the ratio is contractionary. It is one of the central bank's monetary policy tools.
Required Reserve Ratio: a worked example
A bank reports $80,000 of checkable deposits and holds $12,000 of total reserves, so it is holding 12,000 / 80,000 = 15% of deposits. With a required reserve ratio of 12%, required reserves are 0.12 x $80,000 = $9,600, which leaves excess reserves of $12,000 - $9,600 = $2,400. The money multiplier is 1 / 0.12, so those excess reserves can support $2,400 / 0.12 = $20,000 of new money across the banking system. Cut the ratio to 10% and required reserves fall to $8,000, excess reserves rise to $4,000, and the multiplier climbs to 10, so the ceiling doubles to $4,000 x 10 = $40,000 even though the bank never received another dollar.
The mistake students make with required reserve ratio
Multiplying total reserves by the multiplier is the standard trap, and it produces $12,000 / 0.12 = $100,000 instead of $20,000. Required reserves are locked up and cannot be lent, so only excess reserves get multiplied. Subtract required reserves from total reserves first, every single time. The other slip is writing the multiplier as the ratio itself. A 12% requirement gives a multiplier of 1 / 0.12, roughly 8.33, so a smaller ratio means a larger multiplier rather than a smaller one.
Required Reserve Ratio questions
How do you calculate the money multiplier from the required reserve ratio?
The money multiplier equals 1 divided by the required reserve ratio, with the ratio written as a decimal. A 20% requirement gives 1 / 0.20 = 5, and a 12% requirement gives 1 / 0.12, about 8.33. Multiply excess reserves by that figure to find the maximum new money the banking system can create. The answer is a ceiling, since cash holdings and unlent reserves pull the real total lower.
What is the difference between required and excess reserves?
Required reserves are the portion of deposits a bank must hold, found by multiplying deposits by the required reserve ratio. Excess reserves are whatever the bank holds beyond that amount, and only excess reserves can be lent out. A bank with $80,000 of deposits and $12,000 of reserves under a 12% requirement holds $9,600 as required reserves and $2,400 as excess reserves.
What happens to the money multiplier if the required reserve ratio is zero?
A required reserve ratio of zero makes the formula 1 divided by the ratio undefined, so the simple money multiplier stops giving a finite ceiling. Lending is then limited by how much banks choose to keep rather than by law, because a bank still needs reserves to clear payments and cover withdrawals. Deposit expansion continues, but the stopping point comes from desired excess reserves and from how much cash the public holds, not from a legal fraction.
Formula / Example
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