---
title: "Reserve Ratio | Principles of Economics"
description: "Reserve Ratio is the required fraction of deposits banks must hold in reserve, shaping lending, money creation, and monetary policy in Principles of Economics."
canonical: "https://fiveable.me/principles-econ/key-terms/reserve-ratio"
type: "key-term"
subject: "Principles of Economics"
unit: "Unit 27"
---

# Reserve Ratio | Principles of Economics

## Definition

The reserve ratio is the percentage of deposits a bank must keep as reserves instead of lending out. In Principles of Economics, it is a central bank rule that changes how much money banks can create.

## What It Is

The reserve ratio is the fraction of a bank’s deposits that must stay in reserve in a Principles of Economics class. If a bank takes in $100 in deposits and the reserve ratio is 10%, it must keep $10 on hand and can lend out the other $90.

That sounds simple, but it is the starting point for how banks create money under fractional reserve banking. Banks do not lock away every deposit in a vault. They keep only the required reserves plus any extra reserves they choose to hold, and they lend the rest. When a bank makes a loan, the borrower usually gets a deposit in an account, which adds to the money supply.

The reserve ratio is set by the central bank or monetary authority, not by individual banks. A lower ratio gives banks more room to lend, which can expand deposit creation across the banking system. A higher ratio forces banks to hold more funds back, which slows lending and reduces the pace of money creation.

This is why the reserve ratio connects directly to monetary policy. It changes the size of the money multiplier, which is the process that turns one deposit into a larger total amount of money in the economy. In a simplified model, the lower the reserve ratio, the bigger the potential multiplier. Real banking is messier because banks may hold extra reserves and people may keep cash instead of deposits, but the core idea stays the same.

A quick example makes the process easier to see. If someone deposits $1,000 and the reserve ratio is 10%, the bank holds $100 and lends $900. That $900 is spent, deposited again, and partly re-lent, so the original deposit keeps circulating through the banking system. The reserve ratio controls how much of that chain can happen at each step.

## Why It Matters

Reserve ratio shows up anywhere your economics class explains how money gets created without the central bank printing new currency. It is one of the cleanest ways to see how banks, loans, and deposits connect. If you understand this ratio, you can follow the logic of fractional reserve banking instead of memorizing isolated facts.

It also helps you predict the direction of policy changes. If the reserve ratio rises, bank lending usually becomes more limited. If it falls, banks can expand lending more easily, which can raise spending and economic activity. That cause-and-effect chain is the kind of reasoning teachers often want in short answers, quizzes, and class discussion.

The term also links to broader banking stability. A system with very low reserves can create money faster, but it can also leave banks more exposed if many customers want cash at once. So reserve ratio is not just about growth, it is also about balancing liquidity, lending, and confidence in the banking system.

## Connections

### [Fractional Reserve Banking](/principles-econ/key-terms/fractional-reserve-banking)

The reserve ratio is the rule that makes fractional reserve banking work. Banks keep only a fraction of deposits in reserve and lend the rest, so this term tells you how much they have to hold back. Without the reserve ratio, you cannot explain why banks are able to create deposit money through lending.

### Money Multiplier

The reserve ratio helps determine the money multiplier. In a simplified model, a lower reserve ratio means each round of lending can expand the money supply more. That makes this term a useful tool for calculating or predicting how a deposit can grow into a larger amount of money across the banking system.

### [Bank Lending](/principles-econ/key-terms/bank-lending)

Bank lending is the action that turns reserves into broader money creation. When the reserve ratio is low, banks can lend more of each deposit and create more checking account balances. When it is high, lending slows because more money must stay parked as reserves instead of being loaned out.

### [Bank Runs](/principles-econ/key-terms/bank-runs)

Reserve ratio matters for bank runs because reserves are the cash cushion banks rely on when depositors want their money back. If too many people withdraw at once, a bank may not have enough liquid funds on hand. That is why reserve requirements are tied to confidence, liquidity, and the risk of panic.

## On the AP Exam

A quiz question might ask you to calculate how much a bank must keep in reserve, or to predict what happens to lending if the reserve ratio changes. On a problem set, you may be given a deposit amount and asked to find reserves, excess reserves, and the loanable amount. You may also need to trace what happens after a deposit moves through several banks and explain how the reserve ratio affects the money multiplier. If you see a policy scenario, use the term to describe whether bank lending and the money supply would expand or contract.

## Reserve Ratio vs Capital Adequacy Ratios

Reserve ratio and capital adequacy ratios both limit bank risk, but they are not the same. Reserve ratio deals with how much of deposits a bank must hold in reserve, while capital adequacy ratios deal with how much capital a bank has relative to its risk-weighted assets. One is about liquidity for withdrawals, the other is about overall financial strength.

## Key Takeaways

- The reserve ratio is the required share of deposits a bank must keep as reserves, not lend out.
- A lower reserve ratio usually allows more lending and a larger potential increase in the money supply.
- A higher reserve ratio usually restricts lending and slows deposit expansion.
- The reserve ratio is one of the main pieces behind fractional reserve banking and the money multiplier.
- In economics questions, use it to explain how a policy change affects bank lending, liquidity, and money creation.

## FAQs

### What is reserve ratio in Principles of Economics?

The reserve ratio is the percentage of a bank’s deposits that must be held as reserves. In Principles of Economics, it matters because it limits how much a bank can lend and therefore how much new money the banking system can create.

### How does reserve ratio affect the money supply?

A lower reserve ratio lets banks lend more of each deposit, which can increase deposit expansion and raise the money supply. A higher reserve ratio forces banks to hold more back, so lending and money creation slow down.

### What is the difference between reserve ratio and excess reserves?

The reserve ratio is the required minimum, while excess reserves are anything the bank holds above that minimum. If a bank has excess reserves, it has extra funds it could lend out, but it is not required to do so.

### Can you give a simple reserve ratio example?

If a bank gets a $500 deposit and the reserve ratio is 20%, it must keep $100 and can lend $400. That loan can then be deposited in another bank, continuing the money creation process through fractional reserve banking.

## Related Study Guides

- [27.4 How Banks Create Money](/principles-econ/unit-27/4-banks-create-money/study-guide/RWE3NeRXWNKAK9ya)

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