Assume that the banking system initially has total reserves of €500 billion, whi

Question

Assume that the banking system initially has total reserves of €500 billion, while the reserve requirement is equal to 50%. Assume also that banks hold no excess reserves and households hold no currency. What would happen with total reserves and the total amount of money in the economy if the reserve requirement would decrease to 25%?

A) The amount of money would increase by 50%, while the amount of reserves would remain the same.

B) The amount of money would increase by 100%, while the amount of reserves would decrease by 50%.

C) The amount of money would increase by 50%, while the amount of reserves would decrease by 50%.

D) The amount of money would increase by 100%, while the amount of reserves would remain the same.

Explanation / Answer

As we know that the money supply is given by, “M = m*B”, where “m” be the money multiplier and “B” be the monetary base.

So, if initially the base is “B1” and money multiplier is “m=1/50% = 2”, => the money supply is given by.

=> M1 = 2*B1.

Now, if the “reserve requirement” decreases to “25%”, => the money multiplier also increases to “m2=1/25%=4”. So, now the new money supply is given by, “M2 = m2*B1”.

=> M2 = m2*B1 = 4*B1 = 2*2*B1 = 2*M1, => we can see that the money supply got doubled. So, here the money supply increases by “100%”. Now, as the reserve requirement decreases to “25%”, => the total reserve decreases by “50%”.

So, here “B” be the correct answer.

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