South-Western College Publishing - Economics  
Whoa! China Applies Brakes to Economy
Topic International Finance
Key Words Monetary Policy, Reserve Requirements, and Economic Growth
News Story China's central bank, in an effort to cool their country's surging economy, has increased the reserve ratio that commercial banks are required to hold. The new reserve requirements were not unexpected after the latest figures on growth showed that the Chinese economy grew at 11.3 percent in real terms in the second quarter of 2006. This huge economy is growing at the fastest rate in more than a decade and its rate of growth worries analysts that inflation cannot be far behind.

The People's Bank of China raised the reserve requirement that commercial banks must hold from 8 percent to 8.5 percent of deposits, beginning on August 15, 2006. Increasing reserves is a monetary tool used to tighten the availability of credit and slow spending via a reverse-multiplier effect. The move was aimed precisely at the booming sectors of the economy, including real estate and infrastructure development. The central bank said, "Investment in fixed assets is increasing too fast and credit is growing too rapidly," in a statement on its Web site. "The main purpose of this measure is to strengthen liquidity management and rein in too-speedy growth in credit."

This most recent action by the People's Bank follows other contractionary moves. On April 27, 2006, the bank raised its benchmark lending (or discount) rate on corporate loans by 27 one-hundredths of a percentage point to further decrease business investment. At its last meeting in June, the central bank stepped in to slow inflation by increasing the commercial bank reserve requirement from 7.5 percent to 8.0 percent.

Discussion Questions:
1. Define and discuss the reserve requirement and how it relates to the money multiplier.
2. Visit to name and discuss two additional tools of monetary policy.
Multiple Choice/True False Questions:
1. By increasing the reserve requirement for commercial banks, China is attempting to tighten credit.
  1. True
  2. False
2. China's main inflationary pressure appears to be coming from its huge population and the resulting consumer spending.
  1. True
  2. False
Source David Lague, "China Moves to Curb Lending for Second Time in Five Weeks", The New York Times Online, July 22, 2006.
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