Question

When a central bank increases bank reserves by $1, the money supply rises by more than $1. The amount of extra money created when the central bank increases bank reserves by $1 is called the money multiplier. The initial money supply is $1000, of which $500 is currency held by the public. The desired reserve-deposit ratio is 0.2. Find the increase in money supply associated with an increase in bank reserves of $1, $5, and $10. What is the money multiplier for this economy?

Answer 1

Answer:

Money multiplier for this economy is 5

Explanation:

Initial bank reserves = reserve deposit ratio * $500 = 0.2 * $500 = $100

1) increase in bank reserves by $1 , bank reserve deposit increases from $500 to $101 / 0.2 = $505 and the money supply increases by $505 - $500 = $5

2)  increase in bank reserves by $5 , bank reserve deposit increases from $500 to $105 / 0.2 = $525 and the money supply increases by $525 - $500 = $25

3)  increase in bank reserves by $10 , bank reserve deposit increases from $500 to $110 / 0.2 = $550 and the money supply increases by $550 - $500 = $50

as money supply rises by 5 times the increase in bank reserves , the money multiplier in this economy is 5.