Question

If Government is trying to increase commercial bank's capability to create money by lending operations, then should it increase reserve requirement percentile or decrease it? Given an example in support of your answer.

Answer 1

If government is trying to increase commercial banks capability to create money by lending operations, then it should decrease the reserve requirement percentile. If reserve requirement ratio is reduced, banks will be able to lend more and thus money supply in the economy increases.

Eg: Suppose initial reserve requirement is 8% and deposit is $1000. Thus banks need to keep $800 as reserves with themselves and can lend the remaining ($9200). If the reserve requirement is reduced to 5% , then banks need to keep only $500 as reserves and can lend the remaining ($9500). Thus, there is an increase in lending money by $300. Money supply increases by $300.