Question

What effect might a financial panic have on the money multiplier and the money supply? Why?

Short answer

When there is a financial panic, the amount of deposits $\left(D\right)$decreases due to people's lack of confidence in the financial system and their decision to withdraw their funds from banks. Recall that the currency ratio $\left(c\right)$and excess reserves ratio $\left(e\right)$are calculated as follows:

$c=\frac{C}{D}$where $C$is the desired holdings of currency $e=\frac{ER}{D}$, where $ER$is the excess reserves

A decrease in $D$would increase both $c$and $e.$

Step-by-step solution

Concept Introduction

The money multiplier $m$indicates how much the money supply changes for a given change in the monetary base. It is calculated as:

$m=\frac{1+c}{rr+e+c}$where $rr$is the required reserves ratio

When $e$and $c$increase, $m$decreases because the denominator increases more than the numerator. Hence, the money multiplier decreases.

Explanation

Money supply can be reduced significantly during a financial panic.

Bank account holders withdraw currency from their bank accounts in order to transfer their checkable deposits into currency.

Money supply theory says that when c increases significantly, there will be a fall in the overall level of deposits, resulting in a contraction of the money supply.

Therefore, the money supply declines as a result of a smaller money multiplier.

Final Answer

When e rises, deposits are supported with fewer reserves, causing money to be less plentiful.