It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it’s low, the Fed wants to encourage spending and vice versa).
As a result, short-term market interest rates tend to follow its movement.
The function of the central bank has grown and today, the Fed primarily manages the growth of bank reserves and money supply in order to allow a stable expansion of the economy.
To implement its primary task of controlling money supply, there are three main tools the Fed uses to change bank reserves: A change in reserve ratio is seldom used but is potentially very powerful.
The basic ideas of economic stabilization policy were foreign at the time, dating only from John Maynard Keynes’ work in 1936.
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Thus, the new reserves can be used to support additional loans. The bank in which the original check from the Fed is deposited now has a reserve ratio that may be too high.
In other words, its reserves and deposits have gone up by the same amount; therefore, its ratio of reserves to deposits has risen.
The reserve ratio is the percentage of reserves a bank is required to hold against deposits.
A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money.