Reserve Requirement - Effects On Money Supply

Effects On Money Supply

The reserve requirement can be used as an instrument of monetary policy, because the higher the reserve requirement is set, the less funds banks will have to loan out, leading to lower money creation and perhaps ultimately to higher purchasing power of the money previously in use. The effect is multiplied, because money obtained as loan proceeds can be re-deposited; a portion of those deposits may again be loaned out, and so on. The effect on the money supply is governed by the following formulas:

: definitional relationship between monetary base Mb (bank reserves plus currency held by the non-bank public) and the narrowly defined money supply, M1,

: derived formula for the money multiplier mm, the factor by which lending and re-lending leads M1 to be a multiple of the monetary base,

where notationally,

the currency ratio: the ratio of the public's holdings of currency (undeposited cash) to the public's holdings of demand deposits; and

the total reserve ratio ( the ratio of legally required plus non-required reserve holdings of banks to demand deposit liabilities of banks).

However, in the United States (and other countries except Brazil, China, India, Russia), the reserve requirements are generally not frequently altered to implement monetary policy because of the short-term disruptive effect on financial markets.