What is the purpose of setting reserve requirements?

The purpose of setting reserve requirements is primarily to manage the money supply within the economy. Reserve requirements refer to the regulations set by central banks that dictate the minimum amount of reserves a bank must hold against its deposits. By adjusting these requirements, the central bank can influence how much money banks can lend out.

When reserve requirements are increased, banks are required to hold a larger portion of their deposits in reserve, which limits their ability to create new loans and thus reduces the money supply. Conversely, lowering reserve requirements allows banks to lend more, increasing the money supply. This mechanism plays a crucial role in maintaining economic stability and can help in managing both inflation and economic growth.

While setting reserve requirements can have indirect effects on interest rates and inflation, their primary function is to control how much money is circulating in the economy, making the management of the money supply the main focus. Evaluating banking performance is more about assessing how well financial institutions operate within the regulatory framework rather than a direct purpose of setting reserve requirements.