Question

Although the U.S. Federal Reserve doesn't use changes in reserve requirements to manage the money supply, the central bank of Albernia does. The commercial banks of Albernia have $100 million in reserves and $1,000 million in checkable deposits; the initial required reserve ratio is 10%. The commercial banks follow a policy of holding no excess reserves. The public holds no currency, only checkable deposits in the banking system. How will the money supply change if the minimum reserve ratio rises to 25%?

A.)The money supply contracts by $2,000 million.

B.)The money supply contracts by $600 million.

C.)The money supply contracts by $500 million.

Answer 1

Reserve = $100 million

Money multiplier = (1 / Required reserve ratio) = (1 / 0.1) = 10

If this reserve are lent out, total rise in money supply would be 100 * 10 = $1,000 million

If money multiplier rises to 25%, money multiplier will fall to (1 / 0.25) = 4

New rise in money supply would be 100 * 4 = $400 million

Thus, we can say that fall in required reserve ratio from 10% to 25% will reduce money supply from $1,000 million to $600 million thereby contracting money supply by $600 million.

Option B is correct.