Cash Reserve Ratio
In order to allow a stable expansion of the economy, the Fed primarily manages the growth of bank reserves and money supply through three main tools. To implement the task of controlling the money supply, the Fed may implement a change in reserve requirements, a change in discount rate or make open-market operations.(Cloutier, n.d.)
The cash reserve ratio is the percentage of reserves a commercial bank is required to hold against deposits. If regulators decide to lower the cash reserve ratio, the commercial banks will be able to lend more thus increasing the supply of money or the amount of money in the economy. (Kaplan, 2002)
An increase in the money supply would then lead to an increase in the amount of money that people and firms will be
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Direct and indirect effects could happen as the money supply increases; the direct effect being that people will demand more goods and services and the indirect effect being that people will save more money, depositing this in banks (Monetary Policy, n.d.). Therefore, excess reserves will also increase and the banks will be able to lend out more. Banks will motivate borrowing by lowering interest rates and this will increase the demand for investment and consumption and therefore aggregate demand will increase. Businesses respond to increased sales by producing more, thus increasing production. An increase in production would require more labor, thus lowering unemployment, and raises the demand for capital goods. When the economy starts to rise or is already afloat, stock market prices rise and firms issue equity and debt. When all these happen, prices begin to rise and inflation is then expected (Schwartz, …show more content…
As required, commercial banks keep a set fraction of all accepted deposits on reserve. Accordingly, a central bank can maintain control of this reserves by lending to commercial banks and changing the rate of interest on such loans. A decrease in the interest rate will increase the demand for borrowing and vice versa, an increase in interest rate will decrease the demand. Any change in the demand for money play a role in the setting of price levels. An increase in demand for money will raise spending levels and eventually raise prices. A decrease on the other hand will also result to deflation. (Schwartz,
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