Although the US Federal Reserve doesn\'t use changes in reverse requirement to m

Question

Although the US Federal Reserve doesn't use changes in reverse requirement to manage the money supply, the central bank of Albernia does. The commercial banks of Albernia have $100 million in reserves and $1,000 million in checkable deposits; the initial required reserve ratio is 10%. The commercial banks follow a policy of holding no excess reserves. The public holds no currency, only checkable deposits in the banking system. How will the money supply change if the required reserve ratio falls to 5%? How will the money supply change if the required reserve ratio rises to 25%?

Explanation / Answer

Required reserve ratio is the minimum fraction of the total deposits of customers, which commercial banks have to hold reserves either in cash or in deposits with the central bank.

1. When CRR falls to 5% , it implies banks need to decrease their reserves with the central bank. This would make an increase in the amount available with the banks to give loans to the public. Hence, money supply increases with the decrease in the required reserve ratio.

2. Similarly, when the required reserve ratio is increased, money supply is decreased.

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