d Bank reserves increase, but the money supply does not change. king system has

Question

d Bank reserves increase, but the money supply does not change. king system has $20 million in reserves and has a reserve requirement of 20 percent ss reserves, The public holds $10 million in currency. Bankers previously did not hold any exce but difficult economic times make them decide that it is prudent to hold 25 percent of deposits as reserves. At the same time, the public decides to withdraw $10 million in currency from the banking system. Other things equal, by how much must the Bank of Canada increase bank reserves to keep the money supply the same? a. $10 million b. $12.5 million $50 million No action by the Bank of Canada is necessary. c. d.

Explanation / Answer

There are 20 million reserves (all required and no excess reserves as mentioned) and reserve requirements are 20% so that initially the deposits are worth = 20 x 100/20 = 100 million. Public has 10 million as currency in circulation so that R-D ration is 20% and C-D ratio is 10%. Money multiplier = 1 + C-D/C-D + R-D = (1 + 10%)/(10% + 20%) = 3.66. Since monetary base is C + R = 10 + 20 = 30 million. Hence money supply is 30 million x 3.66 = 110 million.

Now currency becomes 20 million deposits become 90 million C-D ratio is 22.22% and R-D ratio = 25%. Money multiplier = 1 + 22.22%/25% + 22.22% = 2.588. This implies that to maintain money supply at 110 million, monetary base must be 110/2.588 = 42.50.

Since originally monetary base is 30 million, it should increase by 12.50 million to reach 42.50. Option B is correct

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