Question

Explain how an increase in the reserve requirement by the Federal Reserve can lead to a decrease in real GDP.

Answer 1

The federal reserve has several tools to conduct monetary policy. The key tools available with the Federal Reserve are -

1. Changing the Federal Fund Rate
2. Changing the Discount Rate
3. Changing the Reserve Requirement

The reserve requirement is the minimum amount the reserves that banks must hold before giving any loans to consumers or business. Just as an example, when the reserve requirement is 10%, a bank need to hold $10 as mandatory reserve for every $100 in deposits.

When the Federal Reserve increases the reserve requirement, the implication is that the banks and the entire banking system needs to hold more reserves. A direct result is that the total liquidity in the banking system declines.

When liquidity in the banking system declines, the federal fund rate increases. The federal fund rate is the rate at which banks lend to one another on an overnight basis. Decline in liquidity coupled with an increase in federal fund rate implies that the total cost of funds for the banks increases.

The banks respond by increasing the interest rate for consumers and business. As interest rates in the economy increase, consumers are less willing to pursue leveraged spending. At the same time, at higher cost of money, businesses are less willing to pursue investment spending. The overall result is that consumption spending and investment spending declines on a relative basis.

The gross domestic product is given as -

Gross Domestic Product = Consumption Spending + Investment Spending + Government Spending + Net Exports

Therefore, as two key components of the GDP decline on a relative basis ( due to higher interest rates ), the real GDP declines. The Federal Reserve uses this policy when inflation is high. As consumption and investment spending decline on a relative basis, high inflation is curbed.