What is the impact of a decrease in the required reserve ratio on aggregate demand?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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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.

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