Final answer:
Decreasing the interest rate paid on reserves leads banks to lend more, increasing money supply and potentially stimulating economic growth with the trade-off of a higher inflation risk.
Step-by-step explanation:
When the Federal Reserve (the Fed) decreases the interest rate paid on reserves, it incentivizes banks to lend out more of their excess reserves instead of holding them at the central bank. This is because the lower interest paid on reserves makes it less attractive for banks to keep their money parked at the Fed, as they earn less on these reserves. As a result, banks are more likely to offer more loans to businesses and consumers, which increases the money supply in the economy and can lead to lower market interest rates. Increased lending promotes economic activity but comes with the risk of causing inflation if too much money enters the circulation. Lowering interest rates aims to stimulate economic growth, as both businesses and consumers are encouraged to borrow and spend more due to the cheaper cost of borrowing.