12. Banks Drop on Higher Reserve Requirement China\'s central bank will raise it
ID: 1230520 • Letter: 1
Question
12. Banks Drop on Higher Reserve RequirementChina's central bank will raise its reserve ration requirement by a percentage point to a record 17.5 percent by June 25, stepping up a battle to contain lending growth. ... The increase will freeze up about 422 billion yuan of funds, equivalent to 91 percent of the value of new yuan-denominted lonas extended in April. ... The latest move adds to the 614.7 billion yuan removed from the financial system through reserve ration increases since January. China's banks had an average excess reserve deposit ratio of 2 percent as of March 31, down from 3.3 percent in December. The rate that banks charge each other for seven-day loans ... rose to 4.93 percent in Shanghai, the highest since Jan 24, according to China Bond Interbank Market. The gain suggests banks are hoarding cash in anticipation of further reserve ratio requirement increases. ... Every half-point increase in the reserve ratio requirement cuts banks' profits by as much as 1.5 percent, assuming they reduce lending to comply with it, said Li Qing, an anlyst at CSC Sercurities HK Ltd. People's Daily Outline, June 11, 2008
a. Compare the required reserve ratio in China and in the United States.
b. Explain how increasing the required reserve ratio can impact money creation in China's banking system.
c. Why might higher required reserve ratios decrease bank profits?
d. Explain how raising the required reserve ratio changes the interest rate in the short run and draw a graph to illustrate the change.
Explanation / Answer
a. Compare the required reserve ratio in China and in the United States.
The reserve ratios in China are much higher than those held by banks in Canada. The required reserve ratio is 17.5 percent in China. The Bank of Canada sets no required reserves, but bank do hold desired reserves. In September 2008, banks had reserves of $1.20 for every $100 of M1 deposits and $0.60 for every $100 of M2 deposits. Bank reserves are mostly currency.
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b. Explain how increasing the required reserve ratio can impact money creation in China's banking system.
Increasing the required reserve ratio increases banks’ desired reserves. When banks’ desired reserves increase they will make fewer loans so the quantity of money in China decreases. (The Mathematical Note shows that an increase in the desired reserve ratio decreases the money multiplier.)
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c. Why might higher required reserve ratios decrease bank profits?
Funds kept as reserves earn low or zero returns. If banks are required to keep more of their funds as reserves, the total returns they earn decreases so their profit decreases.=
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d. Explain how raising the required reserve ratio changes the interest rate in the short run and draw a graph to illustrate the change.
The increase in the required reserve ratio decreases the quantity of money supplied and the money supply curve shifts leftward from MS0 to MS1. As a result, the interest rate rises, in the figure from 4 percent to 6 percent.
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