Question

Suppose the monetary base is $500 million, the required reserve ratio is 12%, and the currency-deposit ratio is 30%. What would the excess reserve ratio need to be to produce $800 million in the money supply. Holding everything else constant, what effect would an increase in the excess reserve ratio have on the money supply?

Answer 1

Answer)

Monetary base = $500 million

Reserve ratio = r = 0.12

Currency ratio = c = 0.3

Total money supply = $800 million

Let "e" be the excess reserve ratio

Money multiplier with the above ratios can be calculated as :

m = (1 + c)/(c +r + e)

= (1 + 0.3)/(0.3 + 0.12 +e)

m = (1.3)/(0.42 + e)

Total money supply = (initial money) x (m)

800 = (500) x ((1.3)/0.42 + e))

(0.42 + e) = (500/800)x(1.3)

0.42 + e = 0.8125

e = 0.8125 - 0.42

e = 0.3925

So, the excess reserve ratio needs to ne 39.25% in order to achive the money supply of $800 million.

Increase in the excess reserve ratio :

As the excess reserve ratio is increased keeping other things constant, the money supply declines as the excess reserve ratio means that more money is taken out of the banking system and it remains idle due to which the loan making capacity of the banks declines.