If the central bank decreases the amount of reserves banks are required to hold from 20% to 10%, then:

A. the money multiplier will increase and the supply of money in the economy will decrease.

B. both the money multiplier and the supply of money in the economy will decrease.

C. both the money multiplier and the supply of money in the economy will increase.

D. the money multiplier will decrease and the supply of money in the economy will increase.

Question

Business

Madelyn Henson

27 November, 23:07

If the central bank decreases the amount of reserves banks are required to hold from 20% to 10%, then:

A. the money multiplier will increase and the supply of money in the economy will decrease.

B. both the money multiplier and the supply of money in the economy will decrease.

C. both the money multiplier and the supply of money in the economy will increase.

D. the money multiplier will decrease and the supply of money in the economy will increase.

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Answers (1)

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Valentino Leonard · Answer 1

C. both the money multiplier and the supply of money in the economy will increase.

Explanation:

The compulsory deposit is an effective way for the central bank to control the money supply and hence the money multiplier. In periods of inflation, the deposit rate increases, decreasing the amount of money in circulation. The multiplier is the speed with which money circulates in the economy, increasing the amount of transactions. In inflationary periods the multiplier has a bad effect on the economy.

However, in periods of low economic activity, the central bank may decrease the amount of compulsory deposits. Thus, the amount of money banks have to lend is larger and the multiplier will also be larger.

For example: If the deposit rate decreases from 20% to 10%. This means that for every $ 100 banks receive on deposit, they will have to withhold only $ 10 from the Fed. That leaves $ 90 to lend to economic agents. That $ 90 was circulated and re-deposited. With the 10% fee, only $ 9 out of $ 90 will be withheld. Another $ 81 went back into the economy and so on. This is the effect of the multiplier on the economy. Thus, the higher the compulsory deposit rate, the smaller the amount of money in circulation and the lower the effect of the economic multiplier. The opposite is true, the lower the compulsory rate, the greater the amount of money in circulation and the greater the multiplier effect.