Question

How can a central bank control excess demand in an economy by making changes in the legal reserve requirements?

Answer 1

Legal reserve requirements refers to the various reserves requirements which the commercial bank has to maintain with itself as well as with the central bank legally. These includes

1. Cash Reserves Ratio (CRR) refers to the proportion of total deposits of the commercial banks which they must have keep as cash reserves with the central bank. The ratio is fixed by the central bank and is varied from time to time to control the supply of money in the economy depending upon the prevailing situation of inflation or deflation.

2. Statutory Liquidity Ratio (SLR) refers to liquid assets that the commercial banks must hold on daily basis as a percentage of their total deposits. SLR is determined by the central bank and is a legal requirement to be fulfilled by the commercial banks. It includes

a. Cash

b. Gold

c. Unencumbered approved securities

In case of inflation, both the ratios are increased so that commercial banks have very less money left to create credit and in case of deflation, both the ratios are decreased so that there is a huge amount parked with commercial bank to create credit.

In order to control excess demand, the central bank must increase CRR so the credit creation capacity of the commercial banks and the money supply in an economy get decreased. As a result aggregate demand will also fall.