How Does an Increase in Bank Reserve-to-Bank Deposit Ratio Impact Money Supply?

What happens when the bank reserve-to-bank deposit ratio increases?

Select one:

A. increase; increase

B. decrease; decrease

C. decrease; increase

D. increase; decrease

E. remain unchanged; increase

F. increase; remain unchanged

G. remain unchanged; remain unchanged

H. remain unchanged; decrease

I. decrease; remain unchanged

The Impact of an Increase in Bank Reserve-to-Bank Deposit Ratio

If the bank reserve-to-bank deposit ratio increases, the money multiplier will decrease, and the money supply will decrease as well.

The reserve-to-deposit ratio represents the proportion of a bank's deposits that it is required to hold as reserves. When this ratio increases, it means that banks are required to hold a higher percentage of their deposits as reserves. This reduces the amount of money that banks can lend out, which in turn decreases the money multiplier.

Let's consider an example to understand this concept better:

Suppose the reserve-to-deposit ratio increases from 10% to 20%. This means that banks must now hold 20% of their deposits as reserves instead of 10%. Assuming the banking system initially has $100,000 in reserves and $1,000,000 in deposits:

With a reserve ratio of 10%, the money multiplier is 1/0.10 = 10. This means that for every dollar of reserves, banks can lend out $10. Now, with the increased reserve ratio of 20%, banks must hold $200,000 in reserves. The money multiplier is now 1/0.20 = 5. This means that for every dollar of reserves, banks can only lend out $5.

As a result, the money supply decreases from $10,000,000 (10 x $1,000,000) to $5,000,000 (5 x $1,000,000). The decrease in the money multiplier and the subsequent decrease in the money supply illustrate the impact of an increased reserve-to-deposit ratio.