Monetary Policy

Monetary policy refers to actions taken by a central bank, such as the Federal Reserve in the United States or the European Central Bank in the eurozone, to control the money supply and interest rates in the economy.

1. Reserve requirements: When a bank gets money from deposits, they have two choices. They can either store them in reserves or they can loan them out to people looking to borrow money. Banks are required by the central bank to hold a certain percentage of deposits in reserves. For example, if the bank has $5,000,000 in deposits and the reserve requirement is 10%, it must hold at least $500,000 in reserves and can loan out a maximum of $4,500,000. The $500,000 in reserves are known as required reserves, while any additional reserves are known as excess reserves. The central bank can change the reserve requirement to influence the money supply and thus consumer behavior, though this does not happen often as most banks follow an ample reserve system (where they hold significant excess reserves)

A decrease in the reserve requirement means that banks can loan out more money, allowing more money to circulate in the economy and being a form of expansionary fiscal policy.

An increase in the reserve requirement means that banks have less money to loan out, decreasing the amount of money that can circulate through the economy, thus being a form of contractionary monetary policy.