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Banks usually like to lend as much as possible, but the Federal Reserve won't let them - for good reason. In this lesson, you'll learn what a required reserve ratio is and how to calculate it. You'll also have a chance to take a short quiz after the lesson.
Definition of Required Reserve Ratio
Reserves are the portion of bank deposits that banks hold but do not loan out. A required reserve ratio is the fraction of deposits that regulators require a bank to hold in reserves and not loan out. If the required reserve ratio is 1 to 10, that means that a bank must hold $0.10 of each dollar it has in deposit in reserves, but can loan out $0.90 of each dollar. The required reserve ratio is set by the Federal Reserve.
Why Is Required Reserve Ratio Important?
The level of reserves is important for two reasons. First, a bank not only makes a profit by lending but actually creates more money by doing it. The degree to which a bank adds to the money supply is directly related to the required reserve ratio. For example, if a bank has a reserve ratio of 10% and deposits of $1,000,000, it can lend out $900,000. The depositors still have a right to withdraw $900,000, but since everybody doesn't need the money at the same time, the reserve will be able to handle daily withdrawal requests. Thus, the money supply has grown from $1,000,000 to $1,900,000. The $900,000 lent out will be used to buy goods and services. The sellers will deposit their revenue in their banks, which will then loan out 90% of $900,000. The cycle will continue, and the money supply will increase. If the reserve ratio was higher, less money would be created, and if it was lower, more money would be created.
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Reserves are also important exactly because the bank is loaning the money it is obligated to return to you. It must have enough money in reserve - on hand - to honor withdrawal requests. If reserves are insufficient, you may have a run on the bank. A run on a bank occurs when depositors have lost confidence in the security of their money at the bank, and all demand withdrawals at once. If the reserves are insufficient to withstand the run, the bank may fail. Bank failures can have severe ripple effects across an economy if the bank is big enough. Thus, reserves help protect the bank and the economy by ensuring that depositors have confidence that they will have access to their money when they want it.
Formula for Required Reserve Ratio
The reserve ratio is simply a fraction of deposits that banks hold in reserves. You can get the fractional reserve requirement by converting the percentage of deposits required to be held in reserves by 100 and then simplifying the fraction.
For example: If the required reserve ratio is 10%, you can simply convert it to a fraction by dividing this percentage number by 100 to get the ratio of reserves to deposits. Thus, you have ten one-hundredths. This fraction can then be simplified; ten one-hundredths equals one-tenth. A required reserve ratio of 1/10 means that a bank must keep 1/10, or ten cents, of every dollar it holds in deposits in reserves.
Bank reserves are the amount of deposits that a bank does not lend out. The required reserve ratio is the fraction of deposits that the Fed requires banks to hold as reserves. You can calculate the reserve ratio by converting the percentage of deposit required to be held in reserves into a fraction, which will tell you what fraction of each dollar of deposits must be held in reserves.
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