Suppose that the reserve requirement for checking deposits is 20 percent and that banks do not hold any excess reserves. If the Fed sells $3 million of government bonds, the economy's reserves bymillion, and the money supply will bymillion. Now suppose the Fed lowers the reserve requirement to 15 percent, but banks choose to hold another 5 percent of deposits as excess reserves.

True or False: The money multiplier will decrease.

a. True

b. False

True or False: As a result, the overall change in the money supply will decrease.

a. True

b. False

(a) Money supply decreases by $15 million; economy's reserves decreases by $3 million

(b) False

(c) False

Explanation:

(a) Required reserve ratio = 20 percent

Government bonds sold by Fed = $3 million

Money multiplier = 1 : Required reserve ratio

= 1 : 0.20

= 5

Money supply decreases by:

= Money multiplier * Decline in reserves

= 5 * $3 million

= $15 million

Therefore, the economy's reserve decreases by:

= Change in money supply * Required reserve ratio

= $15 million * 0.20

= $3 million.

(b) FALSE.

Now, if central bank reduces the reserve ratio but banks maintain excess reserves,

then the money multiplier:

= 1 : (r+e)

= 1 : (0.15 + 0.05)

= 5

Because money multiplier remains the same.

(c) False.

Since money multiplier remains constant, the overall change in money supply will not increase.