Suppose the banking system has $10 million in reserves, the reserve requirement

Question

Suppose the banking system has $10 million in reserves, the reserve requirement is 20 percent, and there are no excess reserves. The public holds $10 million in cash. The bankers decide that it is prudent to hold some excess reserves, and so begin to hold 25 percent of deposits in the form of reserves. Other things the same, what will this action cause the money supply to do?

a. to change forms, but not size

b. to fall by $10 million

c. to fall by $5 million

d. to fall by $0.5 million

Can someone help me with how to solve this question?

Explanation / Answer

If R = 0:2 and reserves are 10M, deposits are 10M=0:2 = 50M. Changing the reserve ratio to 0:25

means reserves will be (50M)(0:25) = 12:5M, and so in the ?rst round 2:5M will be withdrawn from the

banking system. This causes further withdrawls in round two and all subsequent rounds. The ?nal reduction

is 2:5M=0:25 = 10M.

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