Final answer:
A decrease in required reserves by the Federal Reserve System leads to an increase in money supply and a subsequent reduction in interest rates. This happens because banks can lend more, creating more money in circulation, which reduces the cost of borrowing.
Step-by-step explanation:
If the Federal Reserve System decides to decrease required reserves for the banks, this will cause an increase in money supply and thus, will result in lower interest rates. The mechanism behind this is related to how banks operate and the role of the Federal Reserve in controlling monetary policy.
Banks can lend out more money than they have in reserves, a system known as fractional reserve banking. When the reserve requirement is lowered, banks are able to lend out a greater proportion of their deposits, thereby increasing the money supply in the economy. This increased lending leads to more money circulating, which typically results in lower interest rates as a greater supply of loanable funds becomes available.
Given that the Federal Reserve's decisions are made on economic grounds and are insulated from political forces, this action would be considered only if it aligns with the desired monetary policy outcomes. The decrease in reserve requirements, in addition to stimulating the economy by increasing money supply, also tends to lower the cost of borrowing, evidenced by the reduction in market interest rates.