Banks usually like to lend as much as possible, but the Federal Reserve won’t let them – for good reason. In this lesson, you’ll learn what a required reserve ratio is and how to calculate it. You’ll also have a chance to take a short quiz after the lesson.
Definition of Required Reserve Ratio
Reserves are the portion of bank deposits that banks hold but do not loan out. A required reserve ratio is the fraction of deposits that regulators require a bank to hold in reserves and not loan out. If the required reserve ratio is 1 to 10, that means that a bank must hold $0.10 of each dollar it has in deposit in reserves, but can loan out $0.90 of each dollar. The required reserve ratio is set by the Federal Reserve.
Why Is Required Reserve Ratio Important?
The level of reserves is important for two reasons. First, a bank not only makes a profit by lending but actually creates more money by doing it. The degree to which a bank adds to the money supply is directly related to the required reserve ratio. For example, if a bank has a reserve ratio of 10% and deposits of $1,000,000, it can lend out $900,000. The depositors still have a right to withdraw $900,000, but since everybody doesn’t need the money at the same time, the reserve will be able to handle daily withdrawal requests. Thus, the money supply has grown from $1,000,000 to $1,900,000. The $900,000 lent out will be used to buy goods and services. The sellers will deposit their revenue in their banks, which will then loan out 90% of $900,000. The cycle will continue, and the money supply will increase. If the reserve ratio was higher, less money would be created, and if it was lower, more money would be created.
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