Question

Charlotte withdraws $8,000 from her checkable bank deposit to pay tuition this semester. assume that the reserve requirement is 20% and that banks do not hold excess reserves. look at the scenario money supply changes ii. by how much will the money supply contract as a result of the withdrawal?

Answer 1

Checkable bank deposits are subject to money creation process. Therefore, money supply is given not by just by the initial deposit in to the bank. Money supply is given by multiplying the initial deposit with the inverse of the required reserve ratio. The inverse of the required reserve ratio is given by 1/0.20 which gives 5. Hence, when $8000 is deposited into checkable deposit it ends up creating a total money supply of $8000 x 5 = $40,000. 

When Charlotte withdraws the $8,000 from her account, the $40,000 won't be created instead there will be a rise in money in circulation by $8,000 only which is also part of the money supply. Hence, given Charlotte's withdrawal, money in circulation rises by $8,000 plus $40,000 is not created. Overall, the money supply is reduced by $40,000 - $8,000 = $32,000.