Reserve requirement

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    Central bank thumbnailThe reserve requirement (also known as the cash reserve ratio) is the minimum amount of money that banks must hold in reserve, usually given as a percentage of customer deposits. The cash is normally stored in a vault at the bank or with a central bank and cannot be invested or loaned out to businesses or individuals.

    The requirement is set by each country’s central bank and raising or lowering the reserve requirement will subsequently influence the money supply in the economy.

    How does adjusting the cash reserve ratio affect money supply?

    If the reserve requirement is raised, banks will have less money to loan out and this effectively reduces the amount of capital in the economy, therefore lowering the money supply. It will mean less money for investment and spending, and would stunt the growth of the economy. It would also mean that banks earn less interest and could see their share prices fall.

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    Lowering the reserve requirement will have the opposite effect; banks will be able to lend more which would increase money supply and stimulate economic growth.

    How can adjusting the reserve requirement affect currency value?

    Raising reserve requirements can cause an increase in currency value because when banks are restricted in the amount that they can lend out, they may charge borrowers a higher rate of interest. This is bad news for borrowers, but good news for savers who can benefit from a higher rate of return on their savings. If more capital enters the economy to benefit from those higher interest rates, the value of the currency is likely to increase.

    The opposite is true if reserve requirements are lowered. Banks will be able to lend more and so may offer lower interest rates, which can in turn cause the value of a currency to decrease.

    To learn more about the impact of government and central bank policies, read our lesson:

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