The Fed can adjust required reserves to stimulate the economy. How would lowered required reserves achieve this goal?

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pohnpei397 eNotes educator| Certified Educator

When the Federal Reserve (the Fed) lowers the reserve requirement, there will be more money available in the economy.  That will mean that more loans can be made and more economic activity will (all other things being equal) result.  This will stimulate the economy.

When depositors put money in the bank, the bank is required to keep a certain percentage of that money as reserves.  The percentage that they must keep is the required reserve ratio.  The rest of the money can be loaned out.  When the required reserve ratio is high, a larger percentage of the bank deposits must be held as reserves.  That money cannot be loaned out.  Because it cannot be loaned, it does not help to cause economic activity to occur.

If the Fed lowers the reserve requirement, all of a sudden there will be more money available to be loaned out.  Individuals and businesses can borrow that money.  This will lead to increased economic activity.  That means that the economy will be stimulated.

Thus, lower the required reserve ratio frees up more money to be pumped into the economy in the form of loans.  This achieves the goal of stimulating the economy.