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: -When the Fed increases the reserve requirement then it means the Fed is using a contractionary monetary policy to regulate the economy. So, an increase in reserve requirement will make the banks lend less that in turn reduces the level of money supply in the economy.

Detailed explanation-3: -So the first thing that happens with a decrease in the money supply is that interest rates rise. As interest rates rise, businesses are less willing to invest to borrow for investment spending. And consumers, too, are less willing to borrow to buy cars and homes and so on. Thus spending decreases.

Detailed explanation-4: -Today, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply.