Suppose the Fed raises the required reserve ratio, a move that is normally thought to reduce the money supply. However, banks find themselves with a reserve deficiency after the required reserve ratio is increased and are likely to react by requesting a loan from the Fed. Does this action prevent the money supply from contracting as predicted? Explain your answer.

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12 January, 03:56

Suppose the Fed raises the required reserve ratio, a move that is normally thought to reduce the money supply. However, banks find themselves with a reserve deficiency after the required reserve ratio is increased and are likely to react by requesting a loan from the Fed. Does this action prevent the money supply from contracting as predicted? Explain your answer.

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Elizabeth Kidd · Answer 1

It hinders or prevents the money supply from contracting as much and as fast as it would have contracted if the banks had not gone to the Fed for loans. moreover, it is only a short-run phenomenon. Once the banks repay the Fed loans (probably within the next two to four weeks), reserves will leave the banking system, and the money supply will decline as predicted. The loans the Fed makes to banks create a lag between the increase in the required reserve ratio and the full contractionary effect on bank reserves and the money supply.