Question

If the reserve requirement is 6% and a deposit of $1200 is made how much does the money supply grow?

If the reserve requirement is 11% and a deposit of $1200 is made how much does the money supply grow?

Which reserve requirement would the Federal Reserve use if they wanted to slow economic growth? Which would lead to higher interest rates?

Answer 1

Money multiplier = 1 / Cash reserve ratio

= 1/0.06

= 16.67

So, the increase in money supply =

= Deposit * Money Multiplier

= 1200*16.67

= $20000

Now if the reserve ratio is 12%,

Money multiplier = 1 / 0.12

= 8.33

Increase in money supply =

= Deposit * Money multiplier

= 1200*8.33

= $10000

In order to slow the economic growth, the reserve ratio will be higher and the reserve requirement that the Federal Bank would use is 11%.

By doing this, the money supply will be reduced and hence the economic growth will be reduced.

The rate which would lead to higher interest rates is the higher reserve ratio as this would reduce the amount of lending and would also increase the cost of borrowing money. And as the interest rate would rise, people would look to deposit more money in the bank.

So, the reserve rate which would lead to higher reserve ratio is 11%.

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