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It is generally accepted, that printing money will be inflationary, as it increases the money supply without a corresponding real growth of the economy.

At the same time, if the central bank increases reserve requirements (or the official cash rate/bank rate) this decreases the money supply.

So the question is, if a government, perhaps in a time of need, both prints money in order to carry out some project, and also increases reserve requirements/bank rate in order to conteract the inflationary effect, what are the likely follow on economic effects?

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  • $\begingroup$ hi @tohster - Of the five questions I've asked, two of them are without answers, and three of them were asked recently. One isn't obligated to always accept an answer for each question. I have since accepted one answer. $\endgroup$ – dwjohnston Feb 23 '15 at 1:03
  • $\begingroup$ Fair enough. I've attempted to answer this question assuming that you will honor your social contract with the site and eventually accept an answer on all your questions, whether or not it is mine! $\endgroup$ – tohster Feb 23 '15 at 1:36
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During the global financial crisis of 2008-2009, both the US and UK undertook quantitative easing (QE) in conjunction with a policy to fortify banks against risk by increasing reserve requirements. So there are recent cases which illustrate what happens.

A rise in reserve requirements constrains a bank's ability to lend. So it seems to counteract the idea of QE. So why did both the US and UK implement these two seemingly antithetical policies?

Because the two policies also accomplish other objectives.

  1. An increase in capital requirements for banks was thought to be necessary to restore investor confidence in a badly shaken credit system (raising reserves was not done to counteract inflation). Investors did not have confidence in the quality of assets on bank balance sheets, so requiring banks to retain cash deposits was one way of ensuring that banks had (a) a clear base of assets that were not obfuscated (e.g. subprime); and (b) limitations on how much risk (via lending) they could undertake. So investors could feel safer about their deposits and the fundamental strength of the banking system.

  2. Quantitative easing was aimed at injecting liquidity into an economy paralyzed by loss of confidence and liquidity, resulting in low spending and investment levels. In order to offset the negative effects of raising capital reserves, the QE programs needed to be very large, which is why vast amounts of money were pumped into circulation in both countries.

The second part of your question is around follow-on economic effects. Using the dynamics above you can infer the likely effects.

Raising capital requirements had the effect of exactly that. It also had the effect of requiring larger volume of QE to counteract the drag on lending (in effect, money velocity or money multipler) cause by the higher reserve requirements.
Had QE not been sufficient to overcome the higher capital reserves, you would have seen bank balance sheets swell while lending remained low....which is exactly what happened in the early to mid stages of QE while banks shored up their balance sheets before timidly starting to lend at risk again.

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Reserve requirements are a constraint on deposit creation (inflation), but not for all banks.

Most banks do worry about reserve requirements too much, because if they see a good investment opportunity, they will go for it and borrow the base money they need from other banks. If the base money is scarce, this will drive up inter-bank lending and the central bank will load more to the banking system to make sure that such a lending rate does not change. So in a sense, the tail wags the dog.

So say in an economy of 1000 deposits constrained by 100 reserves (given the reserve requirement), then the banking system can get around such a constraint...by increasing reserves in the aggregate! It simply borrows from other banks more and very indirectly, but very powerfully, the central bank will facilitate this. So the banking system could go from 1000 deposits to 100 reserves...to 2000 deposits to 200 reserves. Same reserve ratio. Same target bank rate.

This is why other matter are used to regulate bank lending (like capital requirements).

A proper strategy to limit bank lending would consist of a combination of reserve ratio changes, capital requirement changes and an increase in the central banks target of interbank lending.

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