Question

Suppose an economy has a total of $750 in $1 bills.

a) Calculate the quantity of money if people hold all money as currency.

b) Calculate the quantity of money if people hold all money as demand deposits and banks maintain a 10% reserve ratio.

Answer 1

The economy has total 750 dollars of fiat money/ monetary base.

i. If all of the money is kept in the form of currency, there will be no money creation in the economy and no banking system will exist. Hence, the quantity of money will be same as the monetary base, equal to 750 dollars

ii. If all the money in the economy is held as demand deposits, which means in the banks, the banks can lend the money further while maintaining a required reserve of 10%. Thus, banks will lead to money creation in the economy.

Quantity of money/Money supply will be equal to money multiplier* monetary base.

Quantity of money = 1/r *monetary base

Where, r is the required reserve ratio and 1/r is the money multiplier

We are given, r= 10%= 0.1

Hence, quantity of money= 1/0.1*750 = 10*750= 7500 dollars

Thus, banks create the 10 times of the original money in the economy