Final answer:
Increasing required reserves causes decreased liquidity, likely leading to higher interest rates, as banks will have less money available for lending. Banks can raise the necessary funds by calling in loans, selling assets, or borrowing, which contracts the money supply.
Step-by-step explanation:
If the Federal Reserve System decides to increase required reserves for the banks, it will cause decreased liquidity in the banking system. This happens because banks will now have to hold a larger portion of their deposits as reserves, reducing the amount available for loans and other investments.
Consequently, with less money available to lend, the reduced supply can lead to an increase in interest rates. When interest rates are higher, borrowers will be less inclined to take out loans, leading to decreased spending and investment within the economy.
Banks that need to increase their required reserves have a few options to come up with the cash. They could call in loans, sell off assets, or borrow money, possibly from the Federal Reserve itself. Each of these actions can lead to a contraction in the overall money supply, as more money is held within banks instead of circulating. The ripple effect of this can influence different sectors of the economy, often leading to a more cautious lending environment.