Question

The initial money supply is $1,000, of which $500 is currency held by the public. The desired reserve-deposit ratio is 0.2. Calculate the increase in the money supply associated with increases in bank reserves of $1, $5, and $10. What is the money multiplier in this economy

Answer 1

Answer:

The money multiplier in this economy is 5

Explanation:

In this question, we are asked to calculate the money multiplier in the economy. The money multiplier in the economy refers to one of the many ratios of commercial bank money to reserve bank money under a fractional-reserve banking system.

The formula for money multiplier is 1/reserve ratio.

Firstly, we calculate the initial bank reserves:

Mathematically:

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

In the individual calculations, it can be seen that the money supply rises by 5 times increase in bank reserve. This means that the money multiplier in this economy is 5