Monetary policy is a policy or a process which is taken by the central bank of a country so that they can control either the cost of short-term borrowing or the monetary base. By applying this policy, the central bank wants to target an inflation rate or want to control the interest rate.
The central bank has four significant monetary policy tools due to which they achieve their monetary policy goals. The monetary policy tools are:
1) Open Market Operations
2) Discount Rate
3) Interest on Reserves
4) Reserve Requirements
Generally, all central banks use these four tools in common, but still, many central banks have more tools at their disposal. These four tools are majorly used for maintaining healthy economic growth.
In this article, we focus on the Reserve Requirements Tool.
Reserve Requirements Tool – In this the banks need to maintain a portion of money in their vaults, or they can just put it in Central bank’s vaults. In simple terms, the banks need to maintain a minimum amount of reserves, and central banks decide that amount. It is majorly used for influencing the country’s borrowing and interest rates. The reserve requirement is also known as the cash reserve ratio.
Banks provide loans to their customers, and that loan is based on the fraction of the cash they are holding in their vaults. The central bank made one rule for them for maintaining this ability that they must keep a portion of deposits with themselves so that they can cover the possible withdrawals. That amount is known as reserve requirement, and it is necessary for every bank to maintain these reserves.
Example – let’s assumes that a bank had $500 million in deposits and currently the cash reserve ratio is 8% that means they must hold 8% of deposits with them. Now, the bank is allowed to lend out of $460 million, which will increases bank credit.
A lower reserve requirement rate is used for expansion of the economy. The lower reserves will pump money into the economy. Due to that, it creates credit, and it will promote businesses, and it will also fulfil the needs of the customers. Low reserve requirement also supports the expansion for bank credit and lower rates.
An increase in the requirements of the reserve, it will reduce the funds in the economy, and it will increase the cost of credit. It is known as a contractionary method. Increase in reserve requirement is usually bad for the business of small banks because they do not have much deposit with them and so that they can’t lend funds as big banks do.
The central banks usually don’t make any changes in reserve requirements. The reason for that is it will be expensive for banks, and these changes will force them to modify their procedures.
The central banks have used many monetary policy tools while dealing with the 2008 financial crisis but now the crisis is over, so they discontinued them. If in future financial crisis happens then they will use those tools.
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