6.1.6.2.3. Reserve Requirements
The Fed also implements monetary policy by manipulating reserve requirements. A reserve requirement refers to the funds that banks are required to hold in reserve against deposits made by their customers. To boost the economy, the Fed lowers the reserve requirements, allowing banks to lend out more money. Americans then have more money available to invest and spend.
To slow the economy and lower inflation, the Fed will raise the reserve requirements, causing banks to reduce the amount of money they have available to lend. This tightening of credit will slow investment in new business and reduce spending, resulting in an economic slowdown. Raising the reserve requirements thus reduces inflation because consumers spend less, driving down prices.
Example: The Fed decides to stimulate the economy by lowering reserve requirements. This releases more money for banks to lend, which floods the economy with money. Interest rates fall, and business investment and employment increase. Increased employment puts more money into consumers’ pockets to spend on goods and services. This, in turn, causes production and employment to increase even further, creating spiraling growth.
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