Question

How would a decrease in the reserve requirement affect the (a) size of the monetary multiplier, (b) amount of excess reserves in the banking system, and (c) extent to which the system could expand the money supply through the creation of checkable deposits via loans?

Short answer

1. Increase in the size of the monetary multiplier.

2. Increase in the ratio of excess reserves.

3. Increase in the extent of the money supply expansion via loans.

Step-by-step solution

Explanation for part (a)

Reserve requirement is the reciprocal of the monetary multiplier. Therefore, a decline in reserve requirements will increase the monetary multiplier.

Explanation for part (b)

The reserve requirement and excess reserve constitute the total reserves of the banking system or an individual bank. Technically, both must sum up to 100% or 1 (in ratio). Hence, both are inversely related and move in opposite directions.

Therefore, a decrease in reserve requirements implies an increase in the excess reserves in the banking system.

Explanation for part (c)

The reserve requirement is inversely related to the banking system’s lending capacity. A smaller reserve requirement ensures a greater lending capacity of the banking system.The extent of money creation through checkable deposits via loans depends on the lending capacity of the banking system.An enormous lending capacity expands the money supply wider.

Hence a decrease in reserve requirement will increase the extent to which the money supply can be expanded.