Problem 27 Explain what will happen to the ... [FREE SOLUTION]

Chapter 14: Problem 27

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

Short Answer

Expert verified

An increase in the reserve requirement leads to a decrease in the money multiplier process, as banks are required to hold more reserves, thus restricting their capacity to lend out as much money. This restricts the money creation process, resulting in a smaller increase in the money supply. The new money multiplier, \(m2 = \frac{1}{rr2}\), is smaller than the initial money multiplier, \(m1 = \frac{1}{rr1}\), due to the higher reserve requirement, \(rr2 > rr1\).

Step by step solution

1. Define the money multiplier

The money multiplier (m) is a measure of how much new money the banking system can create from a certain amount of initial deposits. It is calculated as: \[m = \frac{1}{Reserve \,\, Requirement}\] As banks receive deposits, they keep a certain portion as reserves and lend out the rest. This process continues with each borrower depositing the funds back into the banks, creating more deposits and loans, and so on. The money multiplier quantifies the potential of this process to expand the money supply.

2. Define the reserve requirement

The reserve requirement (rr) is a regulation set by the central bank that determines the minimum amount of deposits that banks must hold as reserves. It is expressed as a percentage of total deposits. For example, if the reserve requirement is 10%, then the banks need to hold 10% of all deposits as reserves and can lend the remaining 90% to borrowers.

3. Explain the initial scenario

Suppose the current reserve requirement is rr1. This means banks are required to hold a certain percentage of their deposits as reserves. The current money multiplier, m1, can be calculated using the formula: \[m1 = \frac{1}{rr1}\]

4. Explain the increase in reserve requirement

Suppose there is an increase in the reserve requirement from rr1 to rr2, with rr2 > rr1. The new, higher reserve requirement means that banks are now required to hold a greater proportion of their deposits as reserves, leaving less available for lending.

5. Calculate the new money multiplier

With the increased reserve requirement rr2, we can calculate the new money multiplier m2 using the same formula: \[m2 = \frac{1}{rr2}\]

6. Comparing the new money multiplier with the initial one

Now compare m2 to m1: \[m2 < m1\] As m2 is smaller than m1, this means that the potential increase in the money supply through the money multiplier process has reduced.

7. Explain the impact on the money multiplier process

When the reserve requirement increases, the money multiplier decreases because banks are required to hold more reserves, thus restricting their capacity to lend out as much money. This restricts the money creation process, leading to a smaller increase in the money supply. In summary, an increase in the reserve requirement will lead to a reduction in the money multiplier process, limiting the expansion of the money supply in the economy.

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