A required reserve ratio is the percentage of cash from customer deposits the Federal Reserve requires banks to hold. For example, if the Federal Reserve sets a 10% reserve ratio, commercial banks must put aside 10% of all customer deposits as reserve cash.
As of January 2016, any bank with less than $15 million in deposits need hold no cash in reserves. Meanwhile, banks with between $15 million and $110 million in deposits need to hold a 3% cash reserve. Banks with more than $110 million in net transactions must hold a 10% cash reserve. The Federal Bank uses the reserve ratio to regulate the money supply.
When the Federal Reserve wishes to stimulate the economy, it lowers the reserve ratio. When the reserved ratio is lowered, commercial banks have more cash on hand to lend out to consumers: basically, the money supply is increased. When the money supply is increased, interest rates will fall to accommodate this increase. This makes it less expensive for consumers to borrow money from banks.
So, not only will individual consumers be more inclined to borrow, businesses will also be more inclined to raise the level of their investments. Additionally, local governments may also borrow more in order to finance public service projects (building roads, repairing bridges, etc). Up to a certain level, all this increased economic activity will stimulate the economy. Continued and sustained borrowing may eventually lead to a negative impact on the economy (a matter for another discussion). When businesses, local governments, and consumers borrow more, aggregate demand increases. All these groups are spending more on goods and services. So, a lower reserve ratio raises the aggregate demand.
Aggregate demand is defined as the total amount of money exchanged for goods and services in an economy.
The formula for aggregate demand is AD = C+I+G+(Nx).
AD= aggregate demand
C= consumer spending on goods and services
I= private investment for capital goods
G= government spending
Nx= net exports
A decrease in the required reserve ratio would, all other things being equal, increase aggregate demand. This is because such a decrease would increase the money supply.
When the required reserve ratio is lowered, banks no longer have to keep as much of their deposits in their banks. Instead, they can loan out more than they previously could. When banks can lend out more money, the money multiplier gets larger and each deposit in a bank increases the money supply more than it previously did.
When this happens, aggregate demand will (again, all other things being equal) rise. This is because there will be more money to borrow and interest rates will go down. This will inspire businesses to borrow more and spend it on capital investments. It will also cause consumers to borrow more in order to buy big-ticket items like homes and cars. Since business investment and consumer spending make up the bulk of aggregate demand, this will cause aggregate demand to go up.
Thus, a decrease in the required reserve ratio will increase the money supply, leading to more lending and, thereby, to higher aggregate demand.