Answer to Question #160028 in Macroeconomics for Labib

Question

.During recessions, banks are

less likely to loan money, and

consumers are less likely to

pursue loans due to economic

uncertainty. The central bank

seeks to encourage increased

lending by banks by

decreasing the reserve ratio,

which is essentially the

amount of capital a

commercial bank needs to

hold onto when making loans.

Now answer the following

questions

1) What is the impact on the

money market?

2) Will there

be any change in the money

supply or demand for money?

3) Compare the situation

before and after the reserve

ration decline.

Answer 1

Solution:

1.). When the central bank decreases the reserve ratio, it lowers the cash amount that banks are required to hold in reserves, allowing them to make more loans to consumers and businesses hence impacting the money market positively.

 

2.). Decreasing the reserve ratio by the central bank will provide the bank's depositories with excess reserves, which can instigate an expansion of bank credit and distribution of loans to businesses and consumers, increasing the nation’s money supply and expanding the economy.

 

3.). The situation before refers to when the ratio reserve was high and the economy experiencing inflation. Here, the increased reserve ratio reduces the volume of deposits that can be supported by a given reserve level. This further reduces the money stock and raises the cost of credit through increased interest rates.

The situation after refers to when the ratio reserve is decreased and the economy is experiencing deflation. The decreased reserve ratio allows banks to have excess reserves, enabling them to have more money to lend and more interest is generated. This further, increases the money stock and reduces the cost of credit through lower interest rates.