Question

Explain what will happen to the money multiplier process if there is an increase in the reserve requirement?

Short answer

In conclusion, an increase in reserve requirements reduces the money multiplier, limiting the extent to which banks can create new money through lending. This restricts the growth of the money supply and can potentially slow down economic growth.

Step-by-step solution

Money Multiplier Concept

The money multiplier process is the expansion of a country's money supply due to banks being able to lend. It is represented by a formula: \(Money \: Multiplier = \frac{1}{Reserve \: Requirement}\) The money multiplier shows the maximum amount of money that is created by banks through lending for every unit of reserves. The reserve requirement is the proportion of deposits that banks are legally required to retain as reserves.

Reserve Requirement Concept

Reserve requirements are regulations imposed by the central bank that require banks to maintain a percentage of their customers' deposits as cash reserves. The reserve requirement affects the money supply in an economy. Higher reserve requirements mean banks must keep more of their deposits as cash and cannot lend as much, whereas lower reserve requirements allow banks to lend more of their deposits, stimulating economic growth.

Increase in Reserve Requirement

When there is an increase in the reserve requirement, banks are required to keep a larger amount of their deposits as cash reserves. As a result, they have less money available to lend out to borrowers.

Impact on Money Multiplier Process

An increase in the reserve requirement leads to a decrease in the money multiplier. With less money available to lend, the banks' lending capacity shrinks, reducing the maximum amount of money that could be created by the banking system through lending. The new money multiplier can be calculated as: \(New \: Money \: Multiplier = \frac{1}{New \: Reserve \: Requirement}\) Since the new reserve requirement is higher, the new money multiplier would be smaller, indicating a smaller expansion of the money supply through the lending process. This in turn can potentially slow down economic growth as there would be less new credit available for businesses and households. In conclusion, an increase in reserve requirements reduces the money multiplier, limiting the extent to which banks can create new money through lending. This restricts the growth of the money supply and can potentially slow down economic growth.