Suppose that we define money as the sum of currency and demand deposits. If people hold...

Suppose that we define money as the sum of currency and demand deposits. If people hold equal amounts of currency and demand deposits and banks maintain a reserve ratio of 10 percent, what is the size of money multiplier? a. 1.8 b. 10 c. 2.5 d. 5

the answer is (a) but i don't know why

Expert Solution

The correct option would indeed be

(a) 1.8

The money multiplier is (for c is cash-deposit ratio, r is required reserve ratio and e is excess reserve ratio), which is usually reduced to in case e is not given and to if both e and c are not given. In this question, we have the currency-deposit ratio as c=1, since people holds same amount of C and D, and we have c=C/D=1. The excess reserve ratio is not mentioned and only required reserve ratio is given, and hence we must use formula to calculate. Hence, we have or or . Hence, option a is correct.

Note that option b and c are tricky, but incorrect. Option b would be correct if c was not mentioned, and option c would be correct if c=0.5 (which one may mistakenly assume for equal C and D proportion).

Rahul Sunny answered 1 year ago

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