Question

Suppose you have $12000 in your checking account. You withdraw $500 cash from your account and hide it under your pillow for future use. If the required reserve ratio is 10%, then what will be the maximum impact on money supply today as a result of your action?

Answer 1

Answer:

money supply decreases by $4,500

Explanation:

Money multiplier (m) = 1 ÷ Reserve required ratio

                                  = 1 ÷ 0.1

                                  = 10

Initial amount of deposits = $12,000

Required reserves = 10% of $12,000

                               = $1,200

Therefore,

Amount that is loaned out by bank = $12,000 - $1,200

                                                          = $10,800 (Monetary base)

Hence, the money supply before the withdrawal is as follows:

= Money multiplier × Monetary base

= 10 × $10,800

= $108,000

When $500 cash withdraw from the bank account:

The amount of deposits reduce to $11,500

Required reserves = 10% of $11,500

                               = $1,150

Therefore,

Amount that is loaned out by bank = $11,500 - $1,150

                                                          = $10,350 (Monetary base)

Hence, the money supply before the withdrawal is as follows:

= Money multiplier × Monetary base

= 10 × $10,350

= $103,500

Reduction in the money supply:

= $108,000 - $103,500

= $4,500

Therefore, the money supply decreases by $4,500.