Reserve ratio and money supply have ________ relationship.

The correct option is a negative.

Understanding Reserve Ratio and Money Supply:

The reserve ratio (or reserve requirement) is the percentage of total deposits that commercial banks are legally required to keep as reserves with the central bank (or in their vaults) and cannot lend out to borrowers.

The Money Multiplier Effect:

The money supply in an economy is created primarily through bank lending via the money multiplier mechanism. Mathematically, the money multiplier ($m$) is inversely related to the reserve ratio ($r$):

$m=\frac{1}{r}$

Logical Deduction:

1. If the central bank increases the reserve ratio ($r\uparrow$), banks are obligated to hold a larger fraction of their deposits as reserves. As a result, their excess reserves decrease, lowering their capacity to extend loans. Consequently, the money multiplier decreases, which reduces the overall money supply in the economy ($M\downarrow$).

2. Conversely, if the central bank decreases the reserve ratio ($r\downarrow$), banks need to keep less money in reserves and can lend out more. This leads to an expansion of credit and increases the money supply ($M\uparrow$).

Since an increase in the reserve ratio leads to a decrease in the money supply, and a decrease in the reserve ratio leads to an increase in the money supply, the two variables move in opposite directions. Therefore, reserve ratio and money supply have an inverse or negative relationship.