Question

Although the U.S. Federal Reserve doesn’t often use changes in reserve requirements to manage the money supply, the central bank of Albernia does. The commercial banks of Albernia have $100 million in reserves and $1,000 million in checkable deposits; the initial required reserve ratio is 10%. The commercial banks follow a policy of holding no excess reserves. The public holds no currency, only checkable deposits in the banking system. a. The money supply could potentially (increase, decrease) ________ by $ _____ million if the required reserve ratio falls to 5%. b. Assume part (a) did not occur (the reserve ratio is still 10%). The money supply could potentially (increase, decrease) ________ by $ _____ million if the required reserve ratio rises to 25%.

Answer 1

Answer:

(i) Increases; $1,000 million

(ii) Decreases; $600 million

Explanation:

Initial required reserve ratio = 10%

(i) If the required reserve ratio falls to 5%.

At 10% required reserve ratio,

Money supply = Reserves ÷ required reserve ratio

                       = $100 million ÷ 0.10

                       = $1,000 million

At 5% required reserve ratio,

Money supply = Reserves ÷ required reserve ratio

                       = $100 million ÷ 0.05

                       = $2,000 million

Money supply increases by $1,000 million.

(ii) If the required reserve ratio rises to 25%.

At 10% required reserve ratio,

Money supply = Reserves ÷ required reserve ratio

                       = $100 million ÷ 0.10

                       = $1,000 million

At 25% required reserve ratio,

Money supply = Reserves ÷ required reserve ratio

                       = $100 million ÷ 0.25

                       = $400 million

Therefore, Money supply decreases by $600 million.