reserve ratio

(noun)

A central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out).

Related Terms

Examples of reserve ratio in the following topics:

  • The Reserve Ratio

    • The reserve ratio is the percentage of deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned.
    • The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impact the amount of loanable funds available .
    • Money growth in the economy can occur through the multiplier effect resulting from the reserve ratio.
    • For example, a reserve ratio of 20% will result in 80% of any given initial deposit being loaned out and if the process of loaning is assumed to continue, the maximum increase in money expansion specific to an initial deposit at a 20% reserve ratio will be equal to the reserve multiplier 1/(reserve ratio) x the initial deposit.
    • For example, with the reserve ratio (RR) of 20 percent, the money multiplier, m, will be calculated as:

  • Chapter Questions

    • Required reserve ratio equals 5%; the banks hold zero excess reserves, and the public does not withdraw money out of their currency accounts.
    • Required reserve ratio equals 20%; the banks hold zero excess reserves, and the public does not withdraw money out of their currency accounts.
    • Required reserve ratio equals 10%, and the banks hold zero excess reserves.
    • Required reserve ratio equals 10%, and the banks hold zero excess reserves.
    • Identify the currency-deposit ratio, and explain why it changes over time.

  • The Reserve Requirement

    • The Federal Reserve is in charge of setting reserve requirements for all depository institutions in the country.
    • Suppose that the Fed sets the reserve ratio at 10% for net transaction accounts between $6 million and $15 million.
    • The Federal Reserve can adjust reserve requirements by changing required reserve ratios, the liabilities to which the ratios apply, or both.
    • Unless it is accompanied by an increase in the supply of Federal Reserve balances, an increase in reserve requirements (through an increase in the required reserve ratio, for example) reduces excess reserves, induces a contraction in bank credit and deposit levels, and raises interest rates.
    • Conversely, a decrease in reserve requirements, unless accompanied by a reduction in Federal Reserve balances, initially leaves depository institutions with excess reserves, which can encourage an expansion of bank credit and deposit levels and reduce interest rates.

  • The Fractional Reserve System

    • The fraction of deposits that a bank must hold as reserves rather than loan out is called the reserve ratio (or the reserve requirement) and is set by the Federal Reserve.
    • Excess reserves plus required reserves equal total reserves.
    • First, it can adjust the reserve ratio.
    • A lower reserve ratio means that banks can issue more loans, increasing the money supply.
    • Creating reserves means that commercial banks have more reserves with which they can satisfy the reserve ratio requirement, leading to more loans and an increase in the money supply.

  • The Money Multiplier in Theory

    • That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves; this multiple is the reciprocal of the reserve ratio.
    • We can derive the money multiplier mathematically, writing M for commercial bank money (loans), R for reserves (central bank money), and RR for the reserve ratio.
    • We start with the reserve ratio requirement that the the fraction of deposits that a bank keeps as reserves is at least the reserve ratio:
    • The above equation states that the total supply of commercial bank money is, at most, the amount of reserves times the reciprocal of the reserve ratio (the money multiplier) .
    • A 10% reserve requirement creates a total money supply equal to 10 times the amount of reserves in the economy; a 20% reserve requirement creates a total money supply equal to five times the amount of reserves in the economy.

  • Example Transactions Showing How a Bank Can Create Money

    • When a bank's excess reserves equal zero, it is loaned up.
    • The deposit multiplier is the ratio of the maximum possible change in deposits to the change in reserves.
    • When banks in the economy have made the maximum legal amount of loans (zero excess reserves), the deposit multiplier is equal to the reciprocal of the required reserve ratio ($m=1/rr$).
    • Thus, with a required reserve ratio of 0.1, an increase in reserves of $1 can increase the money supply by up to $10 .
    • Calculate the change in money supply given the money multiplier, an initial deposit and the reserve ratio

  • Reserve Requirement

    • Reserve requirements are the ratio of reserves to deposits that banks must hold to satisfy depositors' withdrawals.
    • Consequently, the Fed can increase the reserve requirement ratio, switching some excess reserves to required reserves.
    • For example, if the required reserve ratio equals 10%, and the Fed buys a $10,000 T-bill using a Fed check, subsequently, the money supply could potentially expand by $100,000 (or $10,000 รท 0.10).
    • Required reserves impose a cost to the banks because they cannot lend these reserves to borrowers, and therefore, do not earn interest income on required reserves.
    • Reserve requirement ratios are components of the money multiplier.

  • Adjusting for LIFO Reserve

    • The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.
    • The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.
    • When dealing with valuing a company using ratios, one must also convert all numbers to FIFO method for easy comparison.
    • This means that, for example, when calculating the current ratio, the LIFO reserve should be added back into the numerator of the equation.
    • Explain how the LIFO reserve is calculated and how to report it on the financial statements

  • The LIFO Reserve

    • The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.
    • Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve.
    • The change in the balance in the LIFO reserve will also increase the current year's cost of goods sold.
    • The disclosure of the LIFO reserve is better for comparing the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.
    • The accounting profession has discouraged the use of the word reserve in financial reporting, so LIFO reserve may sometimes be called: Revaluation to LIFO, Excess of FIFO over LIFO cost, or LIFO allowance.

  • Current Ratio

    • Current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.
    • Reserve requirement - a bank regulation that sets the minimum reserves each bank must hold.
    • Acid Test - a ratio used to determine the liquidity of a business entity.
    • The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.
    • This can allow a firm to operate with a low current ratio.