Variable reserve requirement, Managerial Economics

Variable Reserve Requirement (Cash and Liquidity Ratios)

The Central Bank controls the creation of credit by commercial banks by dictating cash and liquidity ratios.  The cash ratio is:

Cash Reserves

 Deposits

The Central Bank might require the commercial banks to maintain a certain ratio, say 1/10. Hence:

Cash Reserves   =  1

 Deposits                 10

Deposits = 10  x  Cash Reserves

This means that the banks can create deposits exceeding 8 times the value of its liquid assets.  The liquidity ratio can be rewritten as:

 Cash + Reserves Assets   =   Cash           +          Reserves Assets

Deposits                                      Deposits                  Deposits

                                                =  Cash Ratio + Reserve Assets Ratio

If the liquidity ratio is 12.5, then:

Cash              +          Reserved Assets           =  1

Deposits                            Deposits                      8

Deposits = 10 x cash + 2.5 x Reserve Assets.

In most countries the Central Bank requires that commercial banks maintain a certain level of Liquidity Ratio i.e. Cash reserves (in their own vaults and on deposit with the Central Bank) well in excess of what normal prudence would dictate.  This level shall be varied by the Central Bank depending on whether they want to increase money supply or decrease it.

This is potentially the most effective instrument of monetary control in less developed countries because the method is direct rather than via sales of securities or holding bank loans and advances.  The effects are immediate.  This method moreover does not require the existence of a capital market and a variety of financial assets.  However, increased liquidity requirements may still be offset in part if the banks have access to credit from their parent companies.  A further problem is that a variable reserve asset ratio is likely to be much more useful in restricting the expansion of credit and of the money supply than in expanding it:  if there is a chronic shortage of credit-worthy borrowers, the desirable investment projects, reducing the required liquidity.  Ratio of the banks may simply leave them with surplus liquidity and not cause them to expand credit.  Finally, if the banks have substantial cash reserves the change in the legal ratio required may have to be very large.

Posted Date: 11/29/2012 4:52:39 AM | Location : United States







Related Discussions:- Variable reserve requirement, Assignment Help, Ask Question on Variable reserve requirement, Get Answer, Expert's Help, Variable reserve requirement Discussions

Write discussion on Variable reserve requirement
Your posts are moderated
Related Questions
Discuss and analyze following statement: When Burton Cummings graduated with honors from the Canadian Trucking Academy, his father gave him a $350,000 tractor-trailer rig. Rec

Factor combination in the long run In the long run it is possible to vary all factors of production. The firm is therefore restricted in its activities by the law of diminish

How does economic theory contribute to managerial decisions?

The economic cost Unemployment represents a terrible waste of resources and means that the economy is producing a lower rate of output than it could do if there were full empl

Explaination of the Marris Model

Describe the Managerial decisions Managerial decisions are an important component in the working wheel of an organisation. The failure or success of a business depends upon the

Q. Total cost of Factor Combinations? Here we try to find total cost of every factor combination and choose the one that has the least cost. Cost of every factor combination is

Calculate point elasticity of demand for demand function Q=10-2p for decrease in price from Rs 3 to Rs 2

to give presentation on the topic: shutdown and abandoned cost analysis?

features of monopoly?