Question

Consider an economy in which the reserve requirement is increased from 10 percent to 20 percent....

Consider an economy in which the reserve requirement is increased from 10 percent to 20 percent. Explain why the increase in the reserve requirement ratio causes welfare to decline. Use a graph with c2 on the y-axis and c1 on the x-axis to illustrate how the increase in the reserve requirement ratio will affect a person’s lifetime budget constraint.

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Answer #1

Part A

When the reserve requirement increases, it means the money supply will reduce within an economy.This will increase the rate of interest rate hence leading to higher loans,the cost of borrowing will also increase, the production capacity will be lower because the borrowed financial resources will be limited and expensive.The producers will increase the prices of goods and services which will reduce the consumption rates, this has a negative welfare effect on the consumers

Part B

The budget constrain moves to the negative direction because of the harsh economic conditions.

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