Banks assume responsibility for consumer deposits and make money by loaning out deposited finds. Therefore, banks with relatively higher deposits are able to supply a larger amount of loanable funds. The supply of loanable funds directly impacts growth and interest rates in an economy. Typically, an increase in the supply of loanable funds is associated with a decrease in interest rates. The greater the accessibility of loanable funds, as conferred by access and cost, the greater opportunity for businesses and consumers to make investment purchases and increase production and labor supply, respectively.
However, in economic downturns the amount of outstanding loans may be counter to a bank's longevity, as depositors may seek to cash-out holdings. In order to reduce the risk of a panic or "run on bank" from the perception that a bank may not have adequate liquidity to meet depositor access to cash deposits, central banks have adopted policies to ensure that banks use prudent judgement when assessing the amount of deposits to loan.
Reserve Ratio
The reserve ratio is a central bank regulatory tool employed by most, but not all, of the world's central banks. The ratio is a set percentage of customer deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned. Required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank. 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 .
Federal Reserve-US Central Bank
The Federal Reserve is charged with maintaining sustainable economic growth. To carry out its responsibilities, the "Fed" uses policies including the reserve ratio to adjust the money supply to either incentivize growth or slow down growth, as needed.
Monetary policy tool
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:
This then signifies that any initial deposit will contribute to an expansion in money supply up to 5 times its original value.
The conventional view in economic theory is that a reserve requirement can act as a tool of monetary policy. The higher the reserve requirement is set, the theory supposes, the less the amount of funds banks will have to loan out, leading to lower money creation. Alternatively, the higher the reserve requirement the, lower the supply of loanable funds, the higher the interest rate and the slower the resulting economic growth.