Question

1. Why does an increase in reserve requirements cause a decrease in the money supply?

2. Why does a decrease in reserve requirements cause an increase in money supply?

Answer 1

a )An increase in the reserve requirement force the banks to hold a larger sum of money with them all the time. this is the money which they cannot lend. Less lending i.e. a lower supply of loanable fund will increase the interest rate and at a higher interest rate the investment will be low and savings will be high = decrease in the money supply.

b) A lower reserve requirement will allow the banks to lend more therefore more funds and lower interest rate, it will decrease the interest rate and increase the investment = more money supply.