Problem 7 Explain how a decrease in the re... [FREE SOLUTION]

Chapter 13: Problem 7

Explain how a decrease in the required reserve ratio increases the money supply.

Short Answer

Expert verified

A decrease in the required reserve ratio enables banks to loan out more money than they could before. This additional loaned money gets spent and re-deposited in banks, initiating a cycle that results in an overall increase in the money supply.

Step by step solution

Understanding the Reserve Ratio

The reserve ratio is the fraction of total deposits that a bank is required to keep as reserves. Banks are not allowed to lend out this portion of the deposit. For example, if a bank has \$1000 in deposits and the reserve ratio is 10%, it must keep \$100 in reserves and can lend out \$900.

Effect of a Decrease in Reserve Ratio

When the reserve ratio decreases, banks are required to hold less money in reserves. This means that they can lend out more money from their deposits. For example, if the reserve ratio decreases from 10% to 5%, a bank with \$1000 in deposits would then only need to hold \$50 in reserves, freeing up an additional \$50 to be loaned out.

Increase in Money Supply

The money supply in an economy increases when banks lend out more money. This is because the money that banks lend out gets spent, and then re-deposited in banks, creating a cycle that increases the overall money supply. The additional \$50 that the bank can lend out due to the decrease in reserve ratio contributes to this process, therefore increasing the money supply.