Final answer:
Reducing the required reserve ratio from 20% to 10% allows banks to use the newly freed reserves to make loans, expanding the money supply through the money multiplier effect as these loans are deposited and re-lent.
Step-by-step explanation:
When the required reserve ratio falls from 20% to 10%, banks are allowed to hold fewer reserves for the amount of deposits they have. Initially, with $1,000 in total checkable bank deposits and a 20% reserve requirement, banks needed to hold $200 in reserves. This level of reserves was already met, as the total reserves are equal to $200. However, when the reserve requirement is reduced to 10%, the required reserves for $1,000 in deposits drop to $100 ($1,000 * 10%).
This change frees up $100 of the existing reserves ($200 actual reserves - $100 new required reserves). Banks can now use this excess reserve to make new loans. As new loans are made and then deposited into accounts within the banking system, the money supply expands through the money multiplier effect. Essentially, with each round of lending and depositing, banks are holding the required 10% in reserves and loaning out the remaining 90%, which creates new deposits and effectively expands the overall money supply.
It's crucial to note that this theoretical expansion assumes a number of ideal conditions, such as all loans being redeposited into the banking system and that banks lend out all excess reserves. In the real world, factors such as the willingness of banks to lend, the demand for loans, and the holding of currency by the public can influence the actual increase in money supply.