Impact of Reserve Requirement on Bank's "Vault Cash" and Money Supply
In the world of finance, reserve requirements play a crucial role in shaping bank lending, money supply, and economic activity. These requirements, which refer to the percentage of customer deposits that banks must hold in reserve and cannot lend out, are a traditional tool used by central banks to influence the broader economy.
Under expansionary monetary policy, central banks typically reduce reserve requirements, enabling banks to lend out a greater proportion of their deposits. This increase in funds available for lending can potentially boost bank profits through higher interest income. Moreover, the increased money supply leads to lower interest rates, stimulating borrowing, spending, and investment by households and firms. This shift in aggregate demand has the potential to raise output (GDP) and employment, but it also carries the risk of higher inflation if the expansion is excessive.
Conversely, under contractionary monetary policy, central banks may increase reserve requirements to reduce the money supply and curb inflationary pressures. Higher reserve requirements force banks to hold more funds in reserve, reducing the amount available for lending. This can squeeze bank profitability, especially if lending rates remain unchanged. The reduced money supply raises interest rates, discouraging borrowing and spending, and slowing economic growth. This shift in aggregate demand helps control inflation, but at the risk of higher unemployment and lower output.
In modern central banking, especially in the U.S. since the 2008 financial crisis, the Federal Reserve has operated under an ample reserves regime. In this system, reserve requirements have played a diminished role, and the Fed instead uses interest on reserves and open market operations as its primary tools. This shift has simplified bank operations and reduced the effectiveness of reserve requirements as a monetary policy tool.
The reserve requirement is a regulation imposed by central banks on commercial banks, dictating a specific percentage of customer deposits that banks must hold as reserves. This regulation serves to maintain liquidity and safeguard the financial system by providing a safety net in case of unexpected surges in withdrawals and preventing bank runs.
Moreover, the money multiplier (Money Multiplier = 1 / Reserve Ratio) amplifies the impact of a lower reserve ratio. With lower interest rates, businesses are incentivized to take out loans for expansion projects and equipment, and consumers are more likely to take on debt for purchases. On the other hand, raising the reserve ratio during a contractionary monetary policy reduces the amount of money banks can lend, decreasing liquidity, and pushing interest rates to rise.
In conclusion, reserve requirements are a significant tool for central banks to manage the growth of the money supply and use it as a monetary policy tool to control liquidity in the market. While they remain a part of the central bank toolkit, their practical significance has diminished in many advanced economies, where monetary policy increasingly relies on managing the quantity and price of bank reserves rather than statutory requirements.
In the course of expansionary monetary policy, banks may benefit from reduced reserve requirements, which can potentially boost their profits through higher interest income due to increased lending opportunities. On the other hand, during contractionary monetary policy, higher reserve requirements can squeeze bank profitability by limiting the amount available for lending.
In the realm of business, the impact of lower reserve requirements under expansionary monetary policy can stimulate borrowing, spending, and investment, potentially encouraging growth in output (GDP) and employment. However, the increased liquidity can also potentially lead to higher inflation if the expansion is excessive.
