In Westlandia, the public holds 50% of M1 in the form of currency, and the requi

Question

In Westlandia, the public holds 50% of M1 in the form of currency, and the required reserve ratio is 20%. Estimate how much the money supply will increase to a new cash deposit of %500 by completing the accompanying table. (Hint: The first row shows that the bank must hold %100 in minimum reserves - 20% of the %500 deposit - against this deposit, leaving %400 in excess reserves that can be loaned out. However, since the public wants to hold 50% of the loan in currency, only %400 times 0.5 = %200 of the loan will be deposited in round 2 from the loan granted in round 1.) How does you answer compare to an economy in which the total amount of the loan is deposited in the banking system and the public doesn't hold any of the loans in currency? (Hint: Do another table with none of the loan proceeds held in currency.) What does this imply about the relationship between the public's desire for holding currency and the money multiplier?

Explanation / Answer

Simply, the public's desire for holding currency has an inverse relationship with the money multiplier. The money multiplier occurs because of the reserve ratio requirement (the bank is able to loan out more than it has in currency). In the first question, the people with the loan held 50% of the cash rather than using it (purchasing something, which would transfer the funds back to some bank). This inhibits the effect of the money multiplier since the money is half of the money in each transaction is not circulating or being used as required reserves.

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