Why does a reduction in the reserve requirement increase deposit levels? Would this not mean that banks have less demand for deposits and therefore reduce deposit rates OR keep deposit rates the same so they can lend more off the current deposit base?
It’s because under that theory they assume that all money lent out by the bank is deposited into another bank account, I believe it ignores other factors. If the bank is reserving less money then it’s lending out more money and therefore people are depositing this into the bank.
It means that the same dollars get lent and deposited more times on average.
For example, if the reserve requirement is 20%, and $100 is initially deposited, then:
- $100 is deposited, $80 is lent
- $80 is deposited, $64 is lent
- $64 is deposited, $51.20 is lent
- $51.20 is deposited, $40.96 is lent
- and so on
The total of all deposits is $500.
If the reserve requirement is 10%, and $100 is initially deposited, then:
- $100 is deposited, $90 is lent
- $90 is deposited, $81 is lent
- $81 is deposited, $72.90 is lent
- $72.90 is deposited, $65.61 is lent
- and so on
The total of all deposits is $1,000.
When the reserve requirement is lowered by the apex bank, the ability of the commercial banks to give out loans increases, and considering an economy with a cashless policy or an economy with little cash outside the bank, then their will be an increase in the vault cash of the commercial banks as well as velocity of circulation.