Suppose that the reserve requirement for current deposits is 10 per cent and tha

Question

Suppose that the reserve requirement for current deposits is 10 per cent and that banks do not hold any excess reserves If the ECB decides not to renew €1 million of loans it previously made to the euro area banking sector, what is the effect on the economy's reserves and money supply? Now suppose the ECB lowers the reserve requirement to 5 per cent, but banks choose to hold another 5 per cent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

Explanation / Answer

Ans.

1) First of all , let us understand why there is a requirement of reserves in commercial banks? The minimum reserve requirement is a monetary measure for central bank by which ECB can control the supply of money in the economy and inform control inflation and deflation.

Money Multiplier = ( 1 / Reserve Ratio) = (1 / 0.10) = 10.

Now if reserve requirement for current deposits is 10 % , that means commercial banks have to keep a reserve of 10 % of its deposits.If ECB decides not to renew the loans to Euro banking sector, then the MONEY SUPPLY in the economy would reduce by €10 million ( Credit Creation = Money Multiplier(10) × Injection(€1 million ) ) . As €1 million would not be injected in the economy and banks would not be able to give more loans to the public.

b) Even after the ECB lowers the reserve requirement to 5 % , bank might choose to maintain extra 5%as reserves so as to increase the safety in the economic system when there is economic uncertainty and specially during the problems of economic depressions.

Money multiplier is the reciprocal of Reserve Requirement ie Money Multiplier= 1 / Reserve Requirement. Hence when Reserve Requirement increase, money multiplier is reduced and vice versa.

Money supply would obviously be lower as 10% of the deposits would be in reserve. So banks would not be able to lend more.

However, it would be similar to the previous situation. So the second situation would not change.

It's very simple and beautiful concept. Hope you enjoyed learning. Do ask if any doubts left.

Best of Luck ! and Keep Chegging !

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