Question

Using the Aggregate Demand/ Aggregate Supply Model, explain how lowering the reserve ratio affects the economy.

Answer 1

Reserve ratio determines the minimum amount of reserves that each commercial bank must hold. Reserve ratio is determined by the Central Bank of a country. Keeping aside the amount specified by the reserve ratio, Banks loan out or invest the rest of the money. For example, if the reserve ratio is 10%, Banks hold 10% of the deposit as reserves or cash and loans out the rest 90% of the money. If the reserve ratio is lowered, then banks will have more money to loan out. This will increase the amount of money supply in the economy.

As the amount of money supply increases in the economy, at any given demand for money, the supply exceeds demand. There is excess supply in the money market. Excess supply in the money market-implied an excess demand in the bond market, which drives the interest rate down, Thus the output in the economy increase. Excess money supply also decreases the value of money and the price level increases. This happens as the amount of supply remains constant, each unit of money can now buy fewer units of good. Demand for goods increase as people now have more money. Thus, the AD curve shifts to the right. This is shown by the figure below.