What happens if the Federal Reserve lowers the reserve ratio?

The reserve ratio is the amount of reserves—or cash deposits—that a bank must hold on to and not lend out. The greater the reserve requirement, the less money that a bank can potentially lend—but this excess cash also staves off a banking failure and shores up its balance sheet. Still, when the reserve ratio increases, it is considered contractionary monetary policy, and when it decreases, expansionary.

If the Federal Reserve decides to lower the reserve ratio through an expansionary monetary policy, commercial banks are required to keep less cash on hand and are able to increase the number of loans to give consumers and businesses. This increases the money supply, economic growth and the rate of inflation.

What Is the Federal Reserve's Monetary Policy?

The Federal Reserve's monetary policy is one of the ways in which the U.S. government tries to regulate the nation's economy by controlling the money supply. It needs to balance economic growth with increasing inflation. If it adopts an expansionary monetary policy, it increases economic growth but also accelerates the rate of inflation. If it adopts a contractionary monetary policy, it seeks to reduces inflation but also inhibits growth.

The three ways in which the Federal Reserve achieves an expansionary or contractionary monetary policy include the use of the following:

• the discount rate
• the reserve ratio or reserve requirements
• open market operations

How Does the Reserve Ratio Affect the Economy?

The reserve ratio dictates the reserve amounts required to be held in cash by banks. These banks can either keep the cash on hand in a vault or leave it with a local Federal Reserve bank. The exact reserve ratio depends on the size of a bank's assets. The reserve ratio is calculated as:

Reserve Ratio = Reserve Requirements (in dollars) / Deposits (in dollars)

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. But the increased spending activity can also work to increase inflation.

Example

As a simplistic example, assume the Federal Reserve determined the reserve ratio to be 11%. This means if a bank has deposits of $1 billion, it is required to have $110 million on reserve ($1 billion x .11 = $110 million), and could therefore make loans totaling $890 million.

Now, assume the central bank wants to make its monetary policy somewhat more expansionary, and encourage more lending to spur economic activity. To do so, it lowers the reserve ratio to 10%. Now the bank with $1 billion in deposits is required to save $100 million and can lend $900 million (as opposed to $890 million).