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A reserve ratio is the amount of money that a bank must keep on hand, as a percentage of its customers’ deposits. Each country’s central bank determines what the ratio will be for the banks in that country. The money can be kept at the bank itself or in the nearest central bank location. Sometimes this number is called a cash reserve ratio (CRR). The reserve ratio is one of the three major tools of monetary policy, along with the discount rate and open market operations.
The reserve requirements are calculated by multiplying the bank’s book balance, or total deposits on the bank's books, by the reserve ratio. If a bank has $100 million (USD) in deposits on its books, and the reserve ratio is 10 percent, the reserve requirement is $10 million (USD). This means that the bank can lend out $90 million (USD) to its customers.
As the central bank of the United States, the Federal Reserve Bank sets the ratio in the United States and can change it as economic conditions warrant. Since the reserve ratio affects the money supply, the Federal Reserve Bank can adjust the rate to effect changes in economic policy. A change in the ratio can have a significant impact on interest rates and inflation, so changes are made only rarely, and in small increments.
The effect of changing the reserve ratio is called the multiplier effect. A decrease in the ratio means that banks have more money to lend. The loaned money is then deposited in another institution, which can then loan a higher percentage of that money, and so on, multiplying the amount of interest that banks can earn on the original deposit. Conversely, an increase in the ratio results in less money to lend and has the effect of tightening the money supply.
The importance of having a reserve ratio was illustrated in the United States during the Great Depression. Because of the free-fall in the stock market, many people decided that their money was not safe in the bank, so they tried, en masse, to withdraw their deposits. The banks did not have enough cash in reserve to pay all of the depositors, resulting in a ‘run on the bank.’ The government had to step in and declare a bank holiday to give the banks enough time to generate the required cash, and many banks that were unable to do so failed.