The reserve ratio is defined as the ratio of reserves to
A money held by banks.
B bonds issued by banks.
C total deposits at banks.
D financial assets at banks.
The correct answer and explanation is:
The correct answer is:
C) total deposits at banks.
Explanation:
The reserve ratio is a key banking and monetary term that refers to the fraction of total deposits that a bank must keep as reserves rather than loan out or invest. More specifically, it is defined as:
Reserve Ratio = (Reserves) / (Total Deposits)
Here’s a breakdown of the components:
- Reserves: This includes cash that banks hold in their vaults plus the deposits they maintain at the central bank.
- Total Deposits: This refers to the total amount of money deposited by customers in the bank, such as checking and savings accounts.
Banks are required by central banks or regulatory authorities to maintain a certain minimum reserve ratio to ensure liquidity and financial stability. This means banks cannot lend out all the deposits they receive because they need to keep some money readily available to satisfy withdrawal demands from customers.
Why is the reserve ratio important?
- Liquidity Management: By maintaining a reserve ratio, banks ensure they have enough cash on hand to meet withdrawal requests and avoid a bank run.
- Monetary Policy Tool: Central banks manipulate reserve ratios as part of monetary policy. Increasing the reserve ratio means banks must hold more money and lend less, which can reduce the money supply and slow down the economy. Conversely, lowering the reserve ratio frees up more funds for lending, potentially stimulating economic activity.
- Risk Control: Maintaining reserves reduces the risk of insolvency by keeping a buffer against unexpected losses or sudden large withdrawals.
Why not the other options?
- A) Money held by banks: This is vague and doesn’t specify what “money” means. The reserve ratio is specifically about reserves relative to deposits, not all money the bank holds.
- B) Bonds issued by banks: Bonds are liabilities, not deposits. The reserve ratio relates to deposits, not bonds.
- D) Financial assets at banks: Banks hold various assets like loans, bonds, and securities, but the reserve ratio specifically focuses on reserves relative to deposits, not the total financial assets.
In summary, the reserve ratio is a regulatory measure that expresses the proportion of total deposits a bank must keep in reserve, ensuring liquidity and stability within the banking system.