Question

In a system of fractional reserve banking, if central bank reduces its lending to the bank, it

a. increases monetary base b. decreases monetary base c. increases money supply d. decreases money supply

Answer 1

The answer is d. It decreases the money supply.

Fractional reserve banking is a system where central bank sets a reserve ratio and all the commercial banks have to keep that percentage of their Bank deposits as the reserve.

So central bank charges a discount rate if the commercial banks borrow from the central bank which is generally 1% higher than the target fed rate. So when the central bank reduces its lending to the commercial banks then commercial banks have to borrow from other banks available i.e. they have to take loans from other banks leading to fewer loans available in the economy. So in turn, it will decrease the money supply in the economy.