National economic policyEffects of the currency-deposit ratio and reserve-deposit ratio increase in money supply of a closed economy. Currency-deposit ratio rely on households preferences, therefore, in a closed economy it cannot be directly controlled by the government, whereas the reserve-deposit ratio rely on bank policies and regulations. In this case, an increase in both currency-deposit ratio and reserve-deposit ratio will have a negative impact on money supply. Reserve-deposit ratio increase due to banks low reserve will lead to a lower money multiplier hence a decline in money supply. In addition, the currency-deposit ratio also increases due to households preference to hold liquid cash, as s result money multiplier will be lowered hence a decline in money supply.
The increase in the currency-deposit ratio implies that money is being withdrawn from the banking system reducing the amount of money available to banks to lend out. The populace view bank deposits in sub crisis situation to be risky. This is because banks are likely to fall during such crisis. Therefore, money creation by banks through money multiplier is limited, hence a fall in money supply. An increase in the reserve-deposit ratio is negatively related to money multiplier and money supply.
The reason is that it will lead to reduction of money available to banks to lend. The banks in times of sub crisis view money lending as a risky adventure. This is because a considerable number of the borrowers are likely to default their debt. During such times, banks prefer holding high reserve-deposit ratio since they believe it is much safer. The main effect of the two changes will be on the monetary base (MB), this is because MB= Currency (Money held by the households) plus Reserves (money held by banks).
The increase in currency-deposit and reserve-deposit ratio will mean a decline in the monetary base. Money supply is, thus, given by monetary base multiplied with the money multiplier. How would economy’s output and interest rate be affected in the short-run? The sub-prime crisis will lead to a reduction in money supply in the economy. Therefore, a reduction in money supply will result in a decline in output and a rise in interest rate.
The effect of a decline in money supply on interest rate and output is best explained using the IS/LM model. During a sub-prime crisis, the banking sector is much affected. With a decrease in money supply, the LM curve shifts from LM0 to LM1. The shift in the LM curve from LM0 to LM1 will result in a rise in interest rate from i0 to i1 and decline in output from Y0 to Y1.Initially, the economy is in equilibrium at a point where i0 and Y0 are at the intersection.
The economy facing a crisis due to the behavior of banks and households is likely to witness a fall in money supply. A fall in money supply will have the LM curve to shift from LM0 to LM1. This will have a different effect on the economy’s interest rate and output. The interest rate will experience an increase in interest rate from i0 to i1, and a decrease in output from Y0 to Y1. Change in interest rate is as a result of an increase in inflation rates.