The reserve ratio is a key metric determined by central banks to maintain the stability of the banking system. It is the minimum amount of cash that a commercial bank must hold in reserve in order to meet customer withdrawals and other liabilities. The logic behind setting the reserve ratio is that if banks don’t have enough cash reserves to fulfil customer withdrawals, then it can potentially cause a financial crisis.

The reserve ratio is also an important monetary policy tool used by the Federal Reserve (Fed) in the United States to control the money supply and manage inflation. When the Fed wants to increase the amount of money available in the economy to stimulate economic activity, it will lower the reserve ratio. By doing so, banks are allowed to make more loans, thereby increasing the money supply. On the other hand, when the Fed wants to decrease the money supply and prevent inflation, it will increase the reserve ratio, thereby reducing the money supply.

In addition to its function as a monetary policy tool, the reserve ratio is also seen as a way to ensure that banks remain healthy and have adequate cash reserves. When banks hold large reserves, they are better equipped to weather unexpected events and remain liquid. This way, they protect the interests of their customers by having a ready supply of cash on hand.

Furthermore, the reserve ratio can also help central banks when it comes to supervision and monitoring of the banking system. It enables central banks to closely monitor the financial health of banks by examining their risk levels. Ultimately, it serves to protect the money supply and help ensure that the banking system is able to function smoothly and efficiently.