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
write a note on marris growth maximising model?

Interest rates Decreasing the rate of interest may not encourage investment but increasing the interest rate tends to lock up liquidity in the financial system.

Labor demand for low-skilled workers in the United States is w= 24 -0.1E where E is the number of workers (in millions) and w is the hourly wage. There are 120 million domestic U.S

Illustrate the application of economic theory to some business problems

The war on drugs is an expensive battle, as a great deal of resources go into catching those who buy or sell illegal drugs on the black market, prosecuting them in court, and housi

Autonomous Expenditure Also called Exogenous expenditure, is any expenditure that is taken as a constant or unaffected by any economic variables within our theory.  For instan

Write on one theory of profit. Profit as rent of ability: one of the most widely known theories of profit was propounded by F.A. Walker. According to him profit is the rent of is t

Refer to above figure. Albania refused to engage in international trade for ideological reasons. To maximize its economic welfare it would choose to produce at which point in the d

Q. What is Transport and Storage Economies? As the output increases, unit cost of transportation of raw materials, intermediate products and finished products fall. This is for

Explain the Decision-making theory Decision-making theory and game theory that recognise the conditions of imperfect knowledge and uncertainty under which business managers ope