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In: Economics

(In Macroeconomics) According to two key assumptions: if individuals/firms decide to hold more cash, the multiple...

(In Macroeconomics) According to two key assumptions: if individuals/firms decide to hold more cash, the multiple expansion of bank deposits will be limited because fewer cash will be available for use as reserves to support checking deposits. Thus, money supply will be small. if banks wish to hold excess reserves, the multiple expansion of bank deposits will be limited. A given amount of cash will support a smaller supply of money than in case when bank hold no excess reserves. What is relationship between the reserve of a bank and its money supply?

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Expert Solution

There is an inverse relationship between the reserve of a bank and its money supply. Reserve of a bank means that a bank needs to hold in reserve a certain amount of funds against the deposits made by the bank customers. Reserve of a bank are determined with the help of reserve ratio which is determined by Fed. A bank can lower reserve of a bank, if reserve ratio is lower, which enables it to provide more loans which consequently increases the overall money supply in the economy. But if Fed wishes to decrease the size of money supply in the economy then it will raise the reserve ratio due to which banks need to hold more funds in reserve of a bank. This is how Fed influences money supply with the help of reserve of a bank. So, there are various monetary policy tools through which supply of money can be increased or decreased. Monetary policy is basically influencing the money supply in the economy with different methods such as open market operations, discount rate & reserve requirements in order to achieve various objectives such as price stability, maximum employment, long term economic growth, etc. So, effective implementation of monetary policy is essential for the growth of the economy.

Also, we can understand the relationship between the the reserve of a bank and its money supply by understanding the meaning of these two assumptions:

The first assumption states that if individuals/firms decide to hold more cash, the multiple expansion of bank deposits will be limited because fewer cash will be available for use as reserves to support checking deposits. Thus, money supply will be small. This means that cash outside the banking system does not support any deposits, so $1 of cash exactly constitutes $1 of money when it is in the hands of the households or businesses. The money supply declines when cash moves from inside the banking system into the hands of households or businesses.

The second assumption states that if banks wish to hold excess reserves, the multiple expansion of bank deposits will be limited. A given amount of cash will support a smaller supply of money than in case when bank hold no excess reserves. This means that when banks hold excess reserves the money creation process would be stopped. If a bank holds excess reserves more than the amount that it lends then the money multiplier would be sharply reduced. So, the multiple expansion of bank deposits will be limited if vast majority of bank reserves are sitting idle instead of being used to create money.


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