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18 April, 16:54

If a bank decides that it wants to hold $1 million of excess reserves, what effect will this have on checkable deposits in the banking system? Assume that the required reserve ratio on checkable deposits is 10% and the public's holdings of currency do not change.

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  1. 18 April, 18:12
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    checkable deposits will decrease by $10 million

    Explanation:

    the money multiplier = 1 / reserve ratio = 1 / 10% = 10

    if the bank decides to hold an extra $1 million in reserves, the effect on the money supply will be = - $1 million x 10 = - $10 million or a $10 million decrease

    the money multiplier measures the banks' capacity to "create money" through borrowing, e. g. a person deposits $100 dollar, then the bank borrows $90 to another client, and the second client's money is also used to lend more money to a third client and so on.
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