Reasons Why the Central Bank of China Declared a Hike in the Cash Reserve Ratio - Essay Example

?Economics Table of Contents Economics Table of Contents 2 Introduction 3 Hike in Cash Reserve Ratio 3 Impact on Money Multiplier 4 Impact on Aggregate Demand 5 Conclusion 5 References 5 Introduction Globalization had proved to be a boon for almost every economy around the world initially. Eventually however, as exchange rate movements attained prominence as a potential drawback in the field of international trade, all nations around the world showed their concern regarding the same. International trade theory establishes that lower the currency rate of exchange, higher will be the net export volume, which is actually beneficial for the economic growth of an economy. China adopted this very strategy and hence, climbed up the peak of growth post globalization, although other economies around the world have to compensate for the same. Hence China received pleas for a currency appreciation from nations around the world; nevertheless, it seldom gave such an action a serious thought as it threatened to slow down its economic growth though in the short run. But, China’s central bank recently exhibited compliance to these external requests when it hiked the minimum cash reserve ratio to be maintained by Chinese commercial banks, by 0.5%. This step however, was a well-thought one as it indirectly also favored the country’s economic growth. Hike in Cash Reserve Ratio Banks normally hold a certain amount of reserves which is a part of the deposits which it receives from its customers. These reserves are held as a shield against any unprecedented crisis befalling the economy. In fact, the amounts that these banks should mandatorily hold back are decided by the apex central monetary body on the basis of a number of factors including the risks of being submerged under a crisis. The central bank normally declares a required reserve ratio which the underlying commercial banks must comply to and maintain as a part of the total deposits which they receive. Out of this reserve requirement that they retain, a certain amount needs to be maintained with the concerned central bank of the country as cash reserve ratio. Purpose of CRR is to act as a shield or protection against any crisis. For instance, in case that any bank needs more money than it has with itself at any point of time; in such situations, the bank might turn towards the concerned central bank which forwards this amount eventually. The Chinese Central Bank announced an additional cash reserve ratio of 0.5% over what the domestic commercial banks had been maintaining initially with the former. This step was believed as a development owing to requests for currency appreciation coming from nations all around the world. Such a measure increased the liabilities of the Chinese Central Bank as more and more cash started flowing in from commercial banks. The commercial banks however, experienced an increase in their assets as a result given that a hike in CRR implied an increase in the reserves of these banks. Impact upon the economy of China Central Bank of China’s policy of increasing the CRR by an additional 0.5%, implied a reduction in the amount that the commercial banks affiliated with it, could advance to potential borrowers. Hence, the primary implication had been a reduction in the amount of money being circulated through the nation. On a secondary basis, to check the amount of loan demands, the commercial banks were instigated to raise the market rate of interest which negatively affected the volume of investments in the economy. Thus, GDP is likely to fall. Moreover, when GDP falls, so does the amount of consumption and investment while, the demand for imports increase. Hence, during the second phase, the economy is characterized by an increased reduction in GDP owing to reductions in consumption, investment and net exports. Impact on Money Multiplier Money multiplier, represented is the rate at which an economy can create credit given the economy’s monetary base; it is represented as, MM = (1 + c/d)/ (r/d + c/d); where, c/d ? Currency-Deposit Ratio and r/d ? Reserve Ratio (Dornbusch, ‘The Money Multiplier’) When the Central Bank of China declared a hike in the reserve ratio, it implied a reduction in the money multiplier. Thus, the amount of money being circulated in the economy falls as a result which implies a reduction in the demand for money and a rise in the amount of deposits being made. So, the marginal propensity to save (MPS) as well as average propensity to save (APS) increases while there is a simultaneous fall in marginal propensity to consume (MPC) as well as average propensity to consume (APC). In addition, as the rate of interest increases as well, there is a fall in the demand for investment loans and hence a slack in the growth of investment. Impact on Aggregate Demand A rise in the cash reserve ratio could lead to a rise in the rate of interest in China. This rise in the rate of interest results to a fall in investment expenditures and hence, aggregate demand of the economy. Moreover, as discussed earlier, the hike in the rate of interest could also result to a fall in present consumption expenditure as well as net exports in case of an open economy resulting to reductions in the aggregate demand. Aggregate supply also falls as people are no longer interested in consuming more at present. Lack of investment activities also leads to a reduction in the employment rate so that consumption demand falls in addition. Moreover, there is a fall in the circulation of money in the nation which takes a toll on the total volume being produced. Hence, the aggregate supply in the economy falls simultaneously. Conclusion One of the prime reasons why the Central Bank of China declared a hike in the cash reserve ratio had been to favor a fall in the circulation of money in the economy. Such a step had been requested since a long time by various economies of the world, although of no avail. However, when China decided such a measure, it had been an attempt to counter any possibilities of inflation owing to increased circulation of money in the economy. Hence, such a step could be regarded as a corrective monetary measure as well. References Dornbusch, R. & Fischer, S. Macroeconomics. 6th Edition. New York: McGraw-Hill, 2005. Read More