What is a required reserve ratio and how does it impact deposit expansion?
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A required reserve ratio is the percentage of deposits that banks are required to hold in reserve. The level of the required reserve ratio determines how much the overall money supply will expand when a given amount of money is deposited in banks.
When you deposit money in a bank, the bank does not simply put the money in a vault and let it sit there. Instead, the bank loans the money out. This allows them to make money using the deposits. However, banks are required to keep some of the money in reserve. This is done so that they will be less likely to run out of money to pay depositors if things go badly and they lose money that they have loaned out.
When a bank loans out money, it is increasing the money supply and expanding total deposits. If I deposit $1000 and the bank loans out $900 of that, there is now $1900 of new money in the banking system even though I only put in $1000. Deposits have expanded by more than I put in. The higher the required reserve ratio, the less the deposits (and the money supply) expand.
That concept was easily comprehended. So the higher the required reserve ratio ($1000:900), the less the deposit expand.
bank loans $900
new money in the banking system is $1900
it takes money to makes money!!!!
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