Deposit Reserve Ratio
The deposit reserve ratio (also called the required reserve ratio, reserve requirement, or cash reserve ratio) is the proportion of customer deposits that banks are required to hold as reserves, either as cash in their vaults or as deposits with the central bank. It is a key instrument of monetary policy.[1]
Definition
The deposit reserve ratio is set by the central bank and applies to the deposits collected by commercial banks. If, for example, the ratio is 10 percent, a bank must hold 10 percent of its deposits as reserves and may lend or invest the remaining 90 percent.[1]
Role in money creation
The reserve ratio is closely linked to the money multiplier, which determines how much money the banking system can create from a given amount of base money:
- Money multiplier = 1 ÷ Reserve ratio
A lower reserve ratio increases the money multiplier, allowing banks to create more money through lending; a higher ratio reduces it. This relationship is a central part of the process of deposit creation in a fractional-reserve banking system.[1]
Use as a policy tool
| Action | Effect |
|---|---|
| Increasing the reserve ratio | Reduces lending capacity; contractionary. |
| Decreasing the reserve ratio | Expands lending capacity; expansionary. |
Despite its power, the reserve ratio is used less actively than open market operations in many countries, because frequent changes can disrupt bank operations. Some central banks, such as the People's Bank of China, use it more actively as a tool of macroprudential policy.[1]