Question

What will happen to the money supply under the following circumstances in a checkable-deposits-only system? a. The required reserve ratio is \(25 \%,\) and a depositor withdraws \(\$ 700\) from his checkable bank deposit. b. The required reserve ratio is \(5 \%,\) and a depositor withdraws \(\$ 700\) from his checkable bank deposit. c. The required reserve ratio is \(20 \%,\) and a customer deposits \(\$ 750\) to her checkable bank deposit. d. The required reserve ratio is \(10 \%,\) and a customer deposits \(\$ 600\) to her checkable bank deposit.

Short answer

a. Withdrawing $700 with a 25% reserve ratio. b. Withdrawing $700 with a 5% reserve ratio. c. Depositing $750 with a 20% reserve ratio. d. Depositing $600 with a 10% reserve ratio. Answer: a. The money supply will decrease by $2,800. b. The money supply will decrease by $14,000. c. The money supply will increase by $3,750. d. The money supply will increase by $6,000.

Step-by-step solution

1. Calculate the initial money supply

To calculate the initial money supply, we need to know the total amount of checkable deposits and the reserve ratio. The total money supply can be found using the money multiplier formula: $ M_0 = \frac{1}{Required \ Reserve \ Ratio} $

a. Withdrawing \(\$700\) with a \(25\%\) reserve ratio

First, calculate the initial money supply using the formula: $ M_0 = \frac{1}{0.25} = 4 $ Now, calculate the change in money supply after the withdrawal: $ ΔM = -\$700 \times 4 = -\$2800 $ Therefore, the money supply will decrease by \(\$2800\).

b. Withdrawing \(\$700\) with a \(5\%\) reserve ratio

First, calculate the initial money supply using the formula: $ M_0 = \frac{1}{0.05} = 20 $ Now, calculate the change in money supply after the withdrawal: $ ΔM = -\$700 \times 20 = -\$14{,}000 $ Therefore, the money supply will decrease by \(\$14{,}000\).

c. Depositing \(\$750\) with a \(20\%\) reserve ratio

First, calculate the initial money supply using the formula: $ M_0 = \frac{1}{0.2} = 5 $ Now, calculate the change in money supply after the deposit: $ ΔM = \$750 \times 5 = \$3750 $ Therefore, the money supply will increase by \(\$3750\).

d. Depositing \(\$600\) with a \(10\%\) reserve ratio

First, calculate the initial money supply using the formula: $ M_0 = \frac{1}{0.1} = 10 $ Now, calculate the change in money supply after the deposit: $ ΔM = \$600 \times 10 = \$6{,}000 $ Therefore, the money supply will increase by \(\$6{,}000\).

Key concepts

Reserve Ratio

The reserve ratio is a crucial concept within the framework of banking and money supply. It's the fraction of deposits that a bank must keep in reserve and not lend out to customers. So, if a bank has 100 dollars in checkable deposits and the reserve ratio is 10%, the bank must keep 10 dollars in reserve.
Lowering the reserve ratio means banks can lend more, increasing the potential money supply. Conversely, a higher reserve ratio reduces the potential money supply as banks keep more in reserves. It's important because banks create money by lending out deposits, so the reserve ratio directly impacts how much new money can be generated from each initial deposit.
The reserve ratio doesn't just stabilize the banking system but also aligns with broader economic policies governing credit availability and inflation control.

Money Multiplier

The money multiplier helps us understand how banks expand the money supply through lending. It's a measure representing how much the money supply can increase with each dollar of reserves. The formula to calculate the money multiplier is: \[ Money \ Multiplier = \frac{1}{Reserve \ Ratio} \]For instance, with a reserve ratio of 10%, the money multiplier would be 10. This means for every dollar held in reserve, up to 10 dollars could be circulating in the economy as new money is created through the lending process.
How the money supply reacts in given scenarios can be analyzed using the money multiplier. If deposits are withdrawn or new deposits are made, the multiplier effect shows the overall impact on the money supply. It's thus a fundamental tool in understanding economic liquidity and how monetary policies can influence economic activity through banking activities.

Checkable Deposits

Checkable deposits are an essential part of daily banking for both consumers and businesses. These are types of bank accounts where the money is readily available for withdrawal through checks, debit card transactions, or direct transfers.
Unlike savings accounts, checkable deposits typically do not earn interest, but they offer liquidity and ease of access. The quick availability of funds makes it a significant component of the money supply and a central part of how the economy functions, letting consumers transact with ease and enabling businesses to manage cash flow responsibly.
These deposits also form the basis upon which banks can extend credit, governed by the reserve ratio. Excess deposits over the required reserves can be lent out, effectively expanding the money supply through what is known as fractional-reserve banking.

Bank Reserves

Bank reserves refer to the cash that banks keep either in their vaults or deposited with the central bank. These reserves are a portion of checkable deposits that a bank must hold and not loan out, as dictated by the reserve ratio.
Having adequate bank reserves is crucial for several reasons. Most importantly, they ensure that banks can meet withdrawal demands from clients. They also act as a buffer, enhancing financial stability and trust in the banking system by preventing bank runs.
Bank reserves play a strategic role beyond immediate liquidity concerns. They are a central bank's tool for implementing monetary policy. By changing the reserve requirements, a central bank can influence lending activities across the economy, altering the money supply and having far-reaching effects on economic growth and inflation rates.