Answer to Question #175944 in Macroeconomics for Graham Ritchie-Newbigin

Question

If the central bank buys 50 of bonds from commercial banks and the target reserve ratio is 5%, everything online indicates that the com bank lends all the new reserves and the money supply increases by 50/0.05 = 1000. But if they lend all the new reserves (meaning the reserves no longer include the 50 increase) and increase their deposits, won't their reserve ratio now be below the target? I would assume the first bank lends 47.5, etc, meaning the total reserves doesn't change. But in this case the deposits increase would only be 47.5/0.05 = 950, which is inconsistent with that I have found online.

Answer 1

If a central bank purchases bonds, money transfers from the central bank to individual banks in the economy, expanding the available money supply. When a central bank issues bonds, money from the economy's individual banks flows into the central bank, reducing the amount of money in circulation.

The reserve ratio is also referred to as reserve ratio

Reserve Ratio Formulae =$\frac{Reserve Maintained with Central bank}{Deposit Liabilities}$

in this case: The reserve ratio is 0.05, therefore, increasing the reserve ratio would mean a reduction in the volume of deposits that can be supported by a given level of reserve and, in the absence of other measures, reduces the money stock and raises the credit cost.

similarly, if commercial banks increase there deposits, there reserve ratio would fall bellow their target since the money in circulation would be reduced.

$\frac{50}{0.05}=1000$

1000, is the commercial bank's total reserve target