Question

2. How does the fractional reserve ratio affect the money multiplier (show formula)? How does the money multiplier help determine the total expansion in money supply following a new deposit of $1 million by the Federal Reserve into the economy?

Answer 1

2.

Money multiplier= 1/Reserve ratio

Suppose initially reserve ratio= 10%= 0.1

Money multiplier= 1/0.1= 10

Now if reserve ratio increases = 20%= 0.2

Money multiplier= 1/0.2= 5

So here we can observe that as reserve ratio increases it cause money multiplier to decrease.

The total expansion in money supply is calculated through new deposit times money multiplier.

Total expansion in money supply= New deposit x Money multiplier

If new deposit= $1 million, then

Total expansion in money supply= $1 million x Money multiplier

For example: If reserve ratio= 10% which implies Money multiplier= 10

Total expansion in money supply= $1 million x 10= $10 million