The central bank of the fictitious country "Alpha" raises bank reserves by $100. What effect will the increase in bank reserves have on the money supply in each of the following situations: a. If the banking system is a 100% reserve banking system, the money supply will increase by $. b. The banking system is a fractional reserve banking system with a desired reserve deposit ratio of 0.25, the money supply will increase by $.

Question

Kason Daniel

Business

28 February, 15:41

The central bank of the fictitious country "Alpha" raises bank reserves by $100. What effect will the increase in bank reserves have on the money supply in each of the following situations: a. If the banking system is a 100% reserve banking system, the money supply will increase by $. b. The banking system is a fractional reserve banking system with a desired reserve deposit ratio of 0.25, the money supply will increase by $.

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Leandro Kaiser · Answer 1

a. If the banking system is a 100% reserve banking system, the money supply will increase by $100. The reason is that

A system in which all the reserves deposited by the customers are 100% available whenever the customer wants to withdraw is known as a 100% reserve banking system.

This is a safer form of banking in that this system prevents banks from making loans out of the reserves. Thus it avoids losses suffered by depositors due to bank failures.

Therefore, if the banking system is a 100% reserve banking system, the money supply will increase by $100 in that only $100 are introduced in the economy and no further money supply will be created by this $100.

b. The banking system is a fractional reserve banking system with a desired reserve deposit ratio of 0.25, the money supply will increase by $400. The reason is explained below:

The system in which part of reserves are available for withdrawal and the rest of the reserves are used to give loans to others so that more money supply can be created in the form of interest is known as the fractional reserve banking system.

The Federal Reserve decides the part which is kept for cash reserves (known as Reserve Ratio).

The formula used to calculate the money supply if there is a reserve ratio is:

Money Multiplier = 1 / Reserve ratio

In the above question, $100 are the reserves and reserve ratio is 0.25, so

Money Multiplier = 1 / Reserve ratio

Money Multiplier = 1 / 0.25

Money Multiplier = 4

This implies that the money supply will increase by 4 times in the economy by the reserves. Hence

Money Supply = $100 x 4

Money Supply = $400.