Simple deposit multiplier Suppose that Julia finds $50,000 in cash in a mattress

Question

Simple deposit multiplier

Suppose that Julia finds $50,000 in cash in a mattress that was given to her and decides to deposit all of the money into her cousin's checking account. If the assumptions of the simple deposit multiplier hold and the required reserve ratio is set at 20%, the banking system will (decrease / increase) the money supply by ($250,000/$200,000/$40,000/$10,000) . (Note: Currency held by the public is counted in the money supply as part of M1.)

Which of the following assumptions is necessary for a change in checkable deposits to be exactly determined by the simple deposit multiplier? (Pick one)

- Banks hold no excess reserves.

- The Fed has set the required reserve ratio between 5% and 10%.

- Banks have perfect information about the creditworthiness of all borrowers.

If the previous assumption did not hold, the change in the money supply would be (greater / less) than the amount you indicated, because: (Pick one)

-The multiplier holds only as long as the required reserve ratio is between 5% and 10%

-Banks would make fewer loans than they would if they could perfectly observe borrowers' true riskiness

-If banks hold excess reserves, they lend less money than they otherwise could

Explanation / Answer

(a) Banking system will increase money supply by $250,000 (= $50,000 / 0.2).

(b) The necessary assumption is:

- Banks hold no excess reserves

(c) If previous assumption did not hold, change in money supply would be less, because

- If banks hold excess reserves, they lend less money

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