ECONOMICS (CBSE/UGC NET)

Detailed explanation-1: -By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks’ reserve requirements, the Fed is able to decrease the size of the money supply.

Detailed explanation-2: -Holding interest on reserves fixed, an increase in bank reserves would increase the aggregate supply of broad liquidity. Thus, open market operations would have the potential to manage productively the aggregate quantity of broad liquidity in the economy independently of interest rate policy.

Detailed explanation-3: -When the Federal Reserve decreases the reserve ratio, it lowers the amount of cash that banks are required to hold in reserves, allowing them to make more loans to consumers and businesses. This increases the nation’s money supply and expands the economy.

Detailed explanation-4: -Every time a dollar is deposited into a bank account, a bank’s total reserves increases. The bank will keep some of it on hand as required reserves, but it will loan the excess reserves out. When that loan is made, it increases the money supply. This is how banks “create” money and increase the money supply.

Detailed explanation-5: -So the first thing that happens with an increase in the money supply is that interest rates fall. As interest rates fall, businesses are more willing to invest to borrow for investment spending. And consumers, too, are more willing to borrow to buy cars and homes and so on. Thus spending increases.