Have you thought of how money is created? You need to understand the mechanism of how money is created because the supply of money has an influence over an economy. If there is large increase in money supply, it encourages economy activities but drives up inflation. If there is a decrease in money supply, it discourages economic activities but could push down prices of goods and running the risk of deflation.
There are generally three ways which central banks control money supply: interest rate, open market operation and changes in the reserve ratio. In this article, I will explain how controlling the reserve ratio of a bank has an influence over money supply.
Let’s assume that the entire market has only one bank and one central bank. We begin by the bank having excess reserve. A reserve is the total amount of coins and notes in the bank’s vault plus the bank’s deposits with the central bank. An excess reserve is the amount of reserve over and above the desired reserve amount. Desired reserve ratio is the amount of reserve to deposits it wants to hold. Excess reserve occurs when central bank purchases government securities from the bank or when the minimum required reserve ratio is lowered by the central bank.
Let’s say that we start with an excess reserve of $100,000 for this bank. This amount is lent out to Mr. A to purchase a house from Mr. B. Mr. B receives this money and retains a portion as currency (defined as coins and notes). The balance amount is deposited back into the bank. For this example, we assume that the currency retained versus deposit is 1:2 or 50 per cent. This ratio is called the currency–drain ratio. Therefore, $33,333 is retained by Mr. B as currency and $66,667 is deposited into the bank. A portion of this new deposit is set aside as reserves by the bank.
Assuming a desired reserve ratio of 1:10 or 10 per cent, $6,667 is kept as reserve while the balance $60,000 is loan out to Mr. C to purchase a car from Mr. D.
Mr. D retains $20,000 in cash and deposits $40,000 into the bank (assuming currency drain ratio of 1:2 as well). Now the bank will set aside 10 per cent of the new $40,000 deposits as reserve while lending out $36,000 to someone else.
The entire process repeats itself until there is no excess reserve left to lend. From the accompanying table above, it can be seen that a $100,000 excess reserve creates $250,000 of currency and deposits. The reverse process occurs when loans are repaid. Money is created and destroyed in this manner.
Changes to the excess reserve occurs when the central bank purchases (sell) government securities from (to) the bank or when the minimum required reserve ratio is changed by the central bank.
People's Bank of China(PBoC) uses the Required Reserve Ratio (RRR) as one of its monetary policy tool. It was announced on 4 January 2019 that the PBoC intends to cut its RRR by 50 basis points on 15th January and another 50 basis points reduction on 25th January 2019. The cut will release RMB 1.5 trillion of liquidity but it is said this is not going to be effective. Why? You can read this article: China Eases Monetary Policy Again, Now What?
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