Reserve Requirement Cut, Rates Fall
Halving the required reserve ratio doubles the deposit multiplier, so the same reserves support twice the deposits: MS shifts right and the nominal interest rate falls.
Reserve Requirement Cut, Rates Fall
Money MarketHalving the required reserve ratio doubles the deposit multiplier, so the same reserves support twice the deposits: MS shifts right and the nominal interest rate falls.
Start at Equilibrium
The money market opens in equilibrium where the downward-sloping money demand curve (MD) crosses the vertical money supply curve (MS). The vertical axis is the nominal interest rate and the horizontal axis is the quantity of money. MS is drawn vertical because the central bank sets the quantity of money no matter what the rate is, so the interest rate is the only thing left to adjust.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Reserve Requirement Cut, Rates Fall, step by step
- 1
Start at Equilibrium
The money market opens in equilibrium where the downward-sloping money demand curve (MD) crosses the vertical money supply curve (MS). The vertical axis is the nominal interest rate and the horizontal axis is the quantity of money. MS is drawn vertical because the central bank sets the quantity of money no matter what the rate is, so the interest rate is the only thing left to adjust.
- 2
The Required Reserve Ratio Falls
The central bank cuts the reserve requirement from 10 percent to 5 percent, so banks must park less of every deposit in reserve. Total reserves in the system have not changed by a single dollar; what changed is that reserves that were required are now excess, and the deposit multiplier itself doubles from 1 over 0.10, which is 10, to 1 over 0.05, which is 20. The same reserve base now supports twice the checkable deposits. The vertical money supply shifts right.
- 3
The Nominal Interest Rate Falls
At the old nominal interest rate households and firms are now holding more money than they want, a surplus of money. They move the excess into bonds, bond prices are bid up, and the nominal interest rate falls until MD meets the new MS. Money demand itself does not move here. The economy slides down along the fixed MD curve to a lower nominal interest rate and a larger quantity of money.
- 4
Cheaper Credit, With One Caveat
A lower nominal interest rate makes mortgages, car loans, and business borrowing cheaper, so investment and interest-sensitive consumption rise and aggregate demand increases. One note for the exam: real central banks rarely touch the reserve requirement anymore. They steer rates with open market operations and the interest they pay on reserves instead. The graph logic is the same either way.
Where it ends up
The required reserve ratio sets the size of the deposit multiplier, so halving it doubles the deposits a fixed reserve base can support: the vertical money supply shifts right and the nominal interest rate falls.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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