What happens if the fed lowers the reserve requirement

Raising the reserve requirement reduces the amount of money that banks have available to lend. Since the supply of money is lower, banks can charge more to lend it. That sends interest rates up. But changing the requirement is expensive for banks. For that reason, central banks don't want to adjust the requirement every time they shift monetary policy. Instead, they have many other tools that have the same effect as changing the reserve requirement.

If the fed funds rate is high, it costs more for banks to lend to each other overnight. That has the same effect as raising the reserve requirement. Conversely, when the Fed wants to loosen monetary policy and increase liquidity, it lowers the fed funds rate target. That makes lending fed funds cheaper. It has the same effect as lowering the reserve requirement.

Here's the current fed funds rate. The Federal Reserve can't mandate that banks follow its targeted rate. The Fed buys securities, usually Treasury notes, from member banks when it wants the fed funds rate to fall. The Fed adds credit to the bank's reserve in exchange for the security.

Since the bank wishes to put this extra reserve to work, it will try to lend it to other banks. Banks cut their interest rates to do so. The Fed will sell securities to banks when it wants to increase the fed funds rate. Banks with fewer fed funds to lend can raise the fed funds rate. That how open market operations work. If a bank can't borrow from other banks, it can borrow from the Fed itself. It also stigmatizes the bank.

Other banks assume no other bank is willing to lend to it. They assume the bank has bad loans on its books or some other risk. As the fed funds rate rises, these four interest rates also rise:. Reset All. Publications What effect does a change in the reserve requirement ratio have on the money supply? August Reserve Requirement Changes Affect the Money Stock Purpose and Functions describes how a change in the reserve requirement ratio affects bank credit and the money stock.

Decreasing the ratios leaves depositories initially with excess reserves, which can induce an expansion of bank credit and deposit levels and a decline in interest rates. Few Changes in Reserve Requirements There are several reasons why reserve requirements are not frequently changed, the most important of which is that open market operations provide a much more precise tool for implementing monetary policy.

Endnotes 1. Introduction to the Fed. The Fed's Roles and Functions. Personal Finance Banking. What Are Reserve Requirements? Key Takeaways Reserve requirements are the amount of funds that a bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdrawals.

Reserve requirements are a tool used by the central bank to increase or decrease the money supply in the economy and influence interest rates. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

Related Terms Why Bank Reserves Matter Bank reserves are the cash minimums financial institutions must retain to meet central bank requirements. Read how bank reserves impact the economy. Excess Reserves Excess reserves are capital reserves held by a bank or financial institution beyond what is required by law or regulations. The Reserve Ratio Explained The reserve ratio is the portion of reservable liabilities that commercial banks must hold onto, rather than lend out or invest. This is a requirement determined by the country's central bank, which in the United States is the Federal Reserve.

What Is the Federal Funds Rate? The federal funds rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight. What Is Monetary Policy? Monetary policy is a set of actions available to a nation's central bank to achieve sustainable economic growth by adjusting the money supply. The Federal Reserve can decrease the money supply by increasing the reserve requirement. Increasing the reserve requirement decreases excess reserves in the system, thereby decreasing loan activity.

The discount rate is the interest rate at which depository institutions can borrow from Federal Reserve Banks. The Federal Reserve can increase the money supply by lowering the discount rate.