If $100 million is withdrawn from the banking system, what would happen to the m
ID: 1221402 • Letter: I
Question
If $100 million is withdrawn from the banking system, what would happen to the money supply, according to the simple deposit multi per, if the required reserve ratio is 4%? What if the required reserve ratio is 6%? What do you think will happen to interest rates is6%? What do you think will happen to interest rates and the overall economy if this change on the required reserve ratio took place? If $100 million is withdrawn from the banking system, what would happen to the money supply, according to the simple deposit multi per, if the required reserve ratio is 4%? What if the required reserve ratio is 6%? What do you think will happen to interest rates is6%? What do you think will happen to interest rates and the overall economy if this change on the required reserve ratio took place?Explanation / Answer
(a) Money multiplier (MM) = 1 / Required reserve ratio = 1 / 0.04 = 25
So, if $100 million is withdrawn, money supply will decrease by $100 million x 25 = $2500 million.
(b) If required reserve ratio is 0.06, MM = 1 / 0.06 = 16.67
So, if $100 million is withdrawn, money supply will decrease by $100 million x 16.67 = $1667 million.
Therefore, decrease in money supply is less when required reserve ratio is higher.
(c) As money supply falls, interest rate rises. The more the decrease in money supply, the higher the interest rate. So, when required reserve ratio rises from 4% to 6%, decrease in money supply is less, and therefore, increase in interest rate is less. Since investment demand is inversely related to interest rate, as interest rate rises at a lower rate, investment demand is relatively higher when interest rate is relatively lower, i.e. when required reserve ratio is 6%. So, real GDP is relatively higher when investment demand is relatively higher, i.e. when required reserve ratio is 6%.
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