Question

Consider a world in which there is no currency and depository institutions issue only transactions deposits. The reserve ratio is $20$ percent. The central bank sells$1$ billion in government securities. What ultimately happens to the money supply?

Short answer

The money supply should function as usual with the added benefits of banks maintaining a twenty percent reserve ratio.

Step-by-step solution

Transaction deposit.

A deposit is a transaction in which something is transferred to another party for safekeeping. In the financial sector, a deposit is a sum of money that is stored or placed in a bank account in order to earn interest.

Reason for the money supply.

The money supply should continue to function normally, with the extra benefit of banks retaining a $20\%$reserve ratio.

Some economists believe that abolishing deposit insurance will benefit the government in the long run because deposits are risk-free currency claims, implying that we operate with $100\%$reserves. If banks were required to maintain a minimum of $25\%$equity, the risk would be transferred back to the banks rather than the government or shareholders.

As a result, banks will invest in lower-risk possibilities and the money supply will grow if the reserve ratio is maintained.