GED Social Studies TestEconomicsMedium
A country's central bank decides to raise the reserve requirement for commercial banks. What is the most likely intended effect of this action on the economy?
- AIncrease the money supply and stimulate economic growth
- BLower interest rates to encourage borrowing
- CIncrease government spending on public works
- DDecrease the money supply and curb inflation
Show answer & explanationAnswer & explanation
Correct answer: D. Decrease the money supply and curb inflation
Raising the reserve requirement means banks must hold more money in reserve and have less available to lend. This reduces the money multiplier effect, decreases the overall money supply, and is a contractionary monetary policy tool used to combat inflation.
Why the other options are wrong
- A. This action would decrease, not increase, the money supply.
- B. A decrease in the money supply typically leads to higher, not lower, interest rates.
- C. Increasing government spending is a fiscal policy tool, not a monetary policy tool implemented by a central bank.
Reserve Requirement
The fraction of deposits that banks must hold in reserve and not lend out.
- Set by the central bank as a monetary policy tool.
- Increasing it reduces the money supply; decreasing it increases the money supply.
- Aims to influence lending capacity and economic activity.
Memory trick: Central banks use a toolkit to control the money flow.