Question

Suppose the banking system has $10 million in reserves and the reserve ratio is 25 percent. then bankers decide to decrease the reserve ratio to 20 percent. how does this decision eventually change the money supply?

a. increases by $0.5 million
b. increases by $10 million
c. increases by $5 million
d. increases by $20 million

Answer 1

When the reserve ratio is decreased from 25 percent to 20 percent, the money supply increases by $0.5 million.

Step-by-step explanation:

When the reserve ratio is 25 percent, banks are required to hold $2.5 million ($10 million * 25%) in reserves. If the reserve ratio decreases to 20 percent, banks only need to hold $2 million ($10 million * 20%) in reserves. The difference between the new and old reserve requirements is $0.5 million ($2.5 million - $2 million). This means that banks now have an extra $0.5 million available to create new loans. Since the reserve ratio change leads to an increase in bank reserves and excess reserves, it enables the banking system to create more money. The money supply increases by the amount of excess reserves created, which in this case is $0.5 million.