Final answer:
The initial withdrawal decreases the money supply by $2,500. Given a reserve ratio of 10% and no cash drain, the money multiplier effect, which is 10 in this case, could potentially lead to a total decrease in the money supply of $25,000 after multiple rounds of the money creation process.
Step-by-step explanation:
The student's question touches on the concept of the money multiplier effect in the banking system and its impact on the money supply. This is a key concept in macroeconomics, specifically in the study of banking and monetary policy.
Calculation of the Change in the Money Supply
When a withdrawal of $2,500 occurs, the money supply initially decreases by that amount since the amount is removed from the banking system. However, because banks adhere to a target reserve ratio of 10%, they must adjust their total reserves accordingly. Without any cash drain and assuming all other factors remain unchanged, the initial decrease is just the $2,500 withdrawn.
Determining the Potential Money Creation Process
The money creation process begins when banks lend out the excess reserves created by subsequent deposits. The money multiplier can be calculated using the formula 1/reserve ratio. With a reserve ratio (v) of 10%, the money multiplier is 10 (1/0.10 = 10). This means that for every dollar of reserves, the banking system can potentially increase the money supply by $10.
Calculation of the Final Change in the Money Supply
Using the money multiplier, the total change in the money supply is the money multiplier times the change in excess reserves. The initial withdrawal reduces reserves by $2,500. However, this withdrawal also reduces potential loanable funds. The potential money creation is then the money multiplier of 10 times the change in reserves, which is -$2,500, leading to a potential decrease in the money supply of $25,000 after multiple rounds of lending and deposits within the banking system.