Question

19. If the ratio of currency to deposits (cr) increases, while the ratio of reserves to deposits (rr) is constant and the monetary base (B) is constant, then: A) it cannot be determined whether the money supply increases or decreases B) the money supply increases C) the money supply decreases. D) the money supply does not change

I know that the money supply (MS) = money multiplier (m) * the monetary base (B). MS=m*B

B is constant, so changes in m will influence the money supply.

I know that m = (cr+1)/(cr+rr). Now, the answer given to us was C. However, wouldn't an increase in cr increase m, not decrease m?

For example, say rr is fixed at 2 (the number is arbitrary since it's fixed) and cr is initially 5. Then m = 6/7. If cr increases to 6, now m = 7/8. So why is the answer C?

Thanks in advance

Answer 1

Theoretically, if currency deposit ratio is increased, it means people are depositing less money in bank and are spending more money in market. Banks with fewer deposits will now have fewer excess reserves to be used as loans. With fewer loans, less money is created and so money supply decreases (relative to previously created money supply)

Money multiplier will decrease. Suppose cr is 20% and rr is 20%. Then money multiplier is 3. Now cr is increased to 30%. Then multiplier is 2.6. Hence when cr is increased, MM declines and so money supply decreases.

(In your numbers, rr cannot be 2. It should be at maximum 1. Now check your multiplier and everything will appear logical).