Now let’s discuss the second tool, which is the required reserve ratio. When you deposit funds into the bank, the bank doesn’t keep 100% of those funds at the bank. The bank keeps a small percentage of funds and lends out the rest to other people or invests it. The required reserve ratio is the percentage of your money that the bank must keep and not use.

Imagine that at Corner Bank, customers have deposited a total of $10,000,000 in their accounts. The Federal Reserve sets the required reserve ratio at 10%. The bank has to keep $1,000,000 of the $10,000,000 in customer deposits. The bank is then free to lend out the other $9,000,000, earning interest on it.

The Federal Reserve can either increase or decrease the required reserve ratio. Let’s discuss the impact that would occur if the Federal Reserve increases the required reserve ratio. The Federal Reserve decides to raise the required reserve ratio from 10% to 15%. Now, instead of keeping $1,000,000 at 10%, the bank has to keep $1,500,000.

Consequently, the bank will have less money to lend to other businesses. Businesses will have less money to borrow and spend, causing a decrease in the money supply.

Study Tip: Raising the required reserve ratio decreases the money supply and decreases economic activity. Decreasing the required reserve ratio increases the money supply and encourages economic activity.