Test B – Question 2

Assume that the central bank is considering raising the required reserve ratio of commercial banks from 10% to 20%.

1. Explain what a “required reserve ratio” is, and state one reason for raising it.
2. Explain and demonstrate, using a numerical example, the effect of raising the required reserve ratio on the consolidated balance sheet of commercial banks (assuming that the commercial banking system is in a steady state). Calculate and demonstrate the quantity of means of payment in the economy before and after the increase.
3. Explain and demonstrate, using the money market and the investment market, how raising the required reserve ratio will affect the interest rate and the level of investment in the economy.

answer:

Section A:

The reserve ratio is the ratio between the total cash in the bank’s coffers and the amount of current accounts that the bank has opened for its customers. The term required reserve ratio refers to a certain reserve ratio that the bank is prohibited from falling below. For example: if the “required reserve ratio” is 0.25, then it means that for every 4 NIS deposited in the bank’s current account – it must hold at least 1 NIS of cash in its coffers as a reserve. When the required reserve ratio is increased, then the bank must reduce the number of current accounts. If, for example, the required reserve ratio increases to 0.5, then for every 1 NIS of cash in the bank’s coffers, it is permitted to hold only 2 NIS of current accounts. In this situation – the amount of money in the economy decreases. (Reminder: Amount of money = cash in the hands of the public + current accounts).

When the quantity of money decreases, interest rates in the economy increase, which can reduce demand in the economy and thus also reduce inflation.

Therefore: One of the reasons for raising the required reserve ratio is the need to lower the level of inflation in the economy.

Note: By the term “cash in the bank’s vault”, we include, in addition to the cash itself, the deposits the bank has with the central bank.

Section B:

A commercial bank’s balance sheet (and thus the consolidated balance sheet of commercial banks) consists of two columns: an assets column and a liabilities column.

For the sake of the example, let’s assume that in the initial state:

1. The bank has 1,000 NIS in cash.
2. The required reserve ratio is 0.25. According to the lending data, the banks are in a stable position – therefore they are exactly at the required reserve ratio.
3. The bank’s equity is zero (for the purpose of solving this question, we will not delve into the term “equity”).
4. The public always decides to deposit all the cash in its possession in the bank (i.e.: cash in the hands of the public = 0).

1. Before raising the required reserve ratio:

Consolidated balance sheet of commercial banks:

Please note: Since the reserve ratio is 0.25, the bank is permitted to open checking accounts for NIS 4,000 and lend an amount of NIS 3,000.

Amount of payment means = cash in hand + checking accounts = 0 + 4,000 = 4,000 NIS

2. After raising the required reserve ratio to 0.5:

In this case, current accounts can total a maximum of 2,000 NIS (the bank has 1,000 NIS in cash and the reserve ratio has increased to 0.5).

Consolidated balance sheet of commercial banks:

Quantity of payment instruments = cash in hand of the public + checking accounts = 0 + 2,000 = 2,000 NIS

Section C:

The interest rate in the economy is determined by the equilibrium between the demand for money (D ₀ ) and the supply of money (S ₀ ). In the initial situation, the equilibrium is at point 0, and therefore the interest rate is R ₀ . Following the increase in the required reserve ratio, there is a decrease in the quantity of money in the economy, that is, the supply of money decreases from S ₀ to S ₁ . As a result, there will be a new equilibrium at point 1, where the interest rate has increased to R ₁ and the quantity of money has decreased to M ₁ .

In other words: the decrease in the amount of money led to an increase in interest rates in the economy. The increase in interest rates reduces the amount of investment in the economy, since it is less profitable for factories and businesses to take out loans to purchase equipment and invest in various projects, because they will be required to pay higher interest rates for the loans.