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.

Key Takeaways

  • 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.
  • If the Federal Reserve lowers the reserve ratio through an expansionary monetary policy, commercial banks are required to hold less cash on hand.

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 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:

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.

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.