Macroeconomics Quiz: Banking And Expansion Of Money Supply
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Banking And Expansion Of Money SupplyQuestion 1 of 20

The First National Bank is fully loaned up, meaning it has zero excess reserves. The required reserve ratio is 20%. A depositor then withdraws $10,000 cash from their checking account. To correct its reserve position without borrowing from other sources, the bank must

reduce its loans and deposits by $8,000.
increase its reserves by liquidating assets or calling in loans totaling $8,000.
increase its reserves by liquidating assets or calling in loans totaling $10,000.
reduce its loans and deposits by $50,000.
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Macroeconomics Quiz

Macroeconomics Quiz: Banking And Expansion Of Money Supply

Practice Banking And Expansion Of Money Supply in Macroeconomics with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

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This quiz focuses on Banking And Expansion Of Money Supply, giving you a quick way to practice the rules, question types, and explanations that matter most for Macroeconomics.

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Question 1

The First National Bank is fully loaned up, meaning it has zero excess reserves. The required reserve ratio is 20%. A depositor then withdraws $10,000 cash from their checking account. To correct its reserve position without borrowing from other sources, the bank must

  1. reduce its loans and deposits by $8,000.
  2. increase its reserves by liquidating assets or calling in loans totaling $8,000. (correct answer)
  3. increase its reserves by liquidating assets or calling in loans totaling $10,000.
  4. reduce its loans and deposits by $50,000.
Explanation: When the depositor withdraws $10,000, the bank's actual reserves fall by $10,000. At the same time, its deposit liabilities fall by $10,000. This reduces its required reserves by 20% of $10,000, which is $2,000. The net effect is that the bank's actual reserves fell by $10,000 while its required reserves only fell by $2,000, leaving it with a reserve deficiency of $8,000. To meet its requirement, the bank must increase its actual reserves by $8,000. It can do this by selling other assets (like securities) or by not renewing/calling in loans of that amount.

Question 2

The Fed conducts an open market sale of $8 billion in securities to banks at a time when the required reserve ratio is 10% and banks are holding excess reserves equal to 3% of their deposits. If banks maintain their excess reserve ratio at 3% after the transaction, what is the total change in checkable deposits throughout the banking system?

  1. Decrease of $53.8 billion, because banks reduce deposits to maintain both required and excess reserve ratios
  2. Decrease of $72.0 billion, because the transaction removes reserves equal to eight times the reciprocal reserve ratio
  3. Decrease of $61.5 billion, because the sale reduces reserves and the effective multiplier accounts for excess reserves (correct answer)
  4. Decrease of $80.0 billion, because the full money multiplier effect applies to the reserve reduction from the sale
Explanation: When the Fed conducts open market operations, you need to consider how changes in bank reserves ripple through the entire banking system via the money multiplier effect. The key insight is that banks holding excess reserves creates a different multiplier than the simple required reserve ratio would suggest. Here's how to solve this step-by-step: First, calculate the effective reserve ratio by adding required reserves (10%) plus excess reserves (3%) = 13% total reserves held. The effective money multiplier is therefore 10.13=7.69\frac{1}{0.13} = 7.69. When the Fed sells $8 billion in securities, it removes $8 billion from bank reserves. The total change in deposits equals the reserve change times the multiplier: $−8×7.69=−61.5-8 \times 7.69 = -61.5 $ billion. Answer A (53.8billion)appearstouseanincorrectcalculationmethod,possiblyconfusingtherelationshipbetweenreserveratiosandthemultipliereffect.AnswerB(53.8 billion) appears to use an incorrect calculation method, possibly confusing the relationship between reserve ratios and the multiplier effect. Answer B (72.0 billion) seems to misapply the reciprocal concept, perhaps using 8 \times \frac{1}{0.10} \times 0.9 = 72 , but this approach is fundamentally flawed. Answer D ($80.0 billion) incorrectly uses only the required reserve ratio (8×10.10=808 \times \frac{1}{0.10} = 80), completely ignoring the excess reserves that banks maintain. The correct answer is C because it properly accounts for both required and excess reserves in calculating the effective multiplier. Study tip: Always remember that excess reserves reduce the money multiplier's effectiveness. When banks hold reserves above requirements, use the total reserve ratio (required + excess) to find the true multiplier, not just the required reserve ratio.

Question 3

A regional banking system starts with $200 million in total deposits and $25 million in reserves. The required reserve ratio is 10%. Following a Federal Reserve open market purchase of $3 million in government securities from these banks, and assuming banks loan out all excess reserves while depositors redeposit all loan proceeds within the same regional system, what will be the new equilibrium level of total deposits?

  1. $260 million, representing the full multiplier effect of the new reserves on the regional deposit base
  2. $280 million, representing the original deposits plus the maximum expansion from the additional reserves (correct answer)
  3. $230 million, representing the initial deposit base plus the direct impact of the Fed's purchase
  4. $250 million, representing the combined effect of existing excess reserves and new reserves from the purchase
Explanation: When you encounter money multiplier problems, you need to identify the initial conditions, calculate existing excess reserves, and then determine the total impact of new reserves through the banking system's lending process. Start by analyzing the initial situation: with $200 million in deposits and a 10% required reserve ratio, banks must hold $$200 × 0.10 = 2020 $ million in reserves. Since they actually hold $25 million, there are already $5 million in excess reserves available for lending. The Fed's $3 million open market purchase adds new reserves to the system, creating 8milliontotalexcessreserves(8 million total excess reserves (5 million existing + $3 million new). With a 10% reserve requirement, the money multiplier is $\frac{1}{0.10} = 10$$. These 8 million in excess reserves can support $$8 × 10 = 8080 $ million in new deposits through the lending and redepositing process. Therefore, total deposits become 200 + 80 = $280$$ million, making B correct. Answer A ($260 million) incorrectly applies the multiplier only to the Fed's $3 million purchase, ignoring the 5millioninexistingexcessreserves.AnswerC(5 million in existing excess reserves. Answer C (230 million) mistakenly treats the Fed's purchase as a simple addition without any multiplier effect. Answer D ($250 million) appears to add the $3 million purchase and apply a partial multiplier, but uses flawed calculations. Study tip: Always check for existing excess reserves before calculating the multiplier effect. Many students focus only on the new injection of reserves and miss that banks may already have lendable funds sitting idle.

Question 4

The Federal Reserve purchases $5 billion in government securities from commercial banks. If the required reserve ratio is 12.5% and banks initially hold no excess reserves, what is the difference between the immediate change in the monetary base and the maximum potential change in the money supply?

  1. $35 billion, because the monetary base increases by $5 billion while money supply can increase by $40 billion (correct answer)
  2. $32 billion, because the monetary base rises by $8 billion while the money supply can expand by $40 billion
  3. $30 billion, because the immediate monetary base change is $10 billion and maximum money supply change is $40 billion
  4. $28 billion, because the monetary base increases by $12 billion while money supply increases by $40 billion maximum
Explanation: When the Fed purchases $5 billion in securities from banks, it pays with newly created money, increasing the monetary base by exactly $5 billion. This $5 billion becomes excess reserves for the banks. With a required reserve ratio of 12.5%, the money multiplier is 1/0.125 = 8. Therefore, the maximum potential increase in money supply is $5 billion × 8 = 40billion.Thedifferencebetweenthemaximummoneysupplychange(40 billion. The difference between the maximum money supply change (40 billion) and the immediate monetary base change ($5 billion) is $40 billion - $5 billion = $35 billion. Choice B incorrectly states the monetary base increases by $8 billion. Choice C incorrectly states the monetary base increases by $10 billion. Choice D incorrectly states the monetary base increases by $12 billion.

Question 5

A banking system has a required reserve ratio of 15%. Bank A receives a new deposit of $20,000 and loans out the maximum amount. The borrower uses $12,000 of the loan to purchase goods from someone who deposits the money in Bank B, and deposits the remaining loan amount in Bank C. Assuming all banks loan out their maximum amounts, what is the total amount of new loans that can be created by Banks B and C combined?

  1. $14,450, representing the sum of maximum loans possible from both banks after setting aside required reserves (correct answer)
  2. $13,685, representing the total lending capacity of both banks based on their respective deposit amounts
  3. $15,230, representing the combined excess reserves available for lending after reserve requirements are met
  4. $12,920, representing the aggregate loan creation potential from the split deposit scenario described
Explanation: Bank A receives 20,000,holds1520,000, holds 15% (3,000) as required reserves, and loans out $17,000. The borrower splits this: $12,000 goes to Bank B and $5,000 goes to Bank C. Bank B receives 12,000,musthold1512,000, must hold 15% (1,800) as reserves, so can loan $10,200. Bank C receives 5,000,musthold155,000, must hold 15% (750) as reserves, so can loan $4,250. Total new loans by Banks B and C = $10,200 + $4,250 = 14,450.ChoiceB(14,450. Choice B (13,685) appears to use an incorrect reserve calculation. Choice C (15,230)overstatesthelendingcapacity.ChoiceD(15,230) overstates the lending capacity. Choice D (12,920) understates the total lending capacity of both banks.

Question 6

The central bank conducts an open market sale of $10 million in government bonds to commercial banks. Assuming a required reserve ratio of 10% and that banks were initially fully loaned up, what is the effect on the monetary base and the maximum potential effect on the M1 money supply?

  1. Monetary base decreases by $10 million; M1 decreases by a maximum of $10 million.
  2. Monetary base is unchanged; M1 decreases by a maximum of $100 million.
  3. Monetary base decreases by $100 million; M1 decreases by a maximum of $100 million.
  4. Monetary base decreases by $10 million; M1 decreases by a maximum of $100 million. (correct answer)
Explanation: When commercial banks buy bonds from the central bank, they pay using their reserves. This reduces total reserves in the banking system by $10 million. The monetary base is defined as currency in circulation plus total bank reserves. Therefore, the monetary base decreases by 10million.Thislossofreservesforcesamultiplecontractionofthemoneysupply.Themoneymultiplieris1/RRR=1/0.10=10.ThemaximumpotentialdecreaseinM1isthechangeinreservesmultipliedbythemultiplier:−10 million. This loss of reserves forces a multiple contraction of the money supply. The money multiplier is 1/RRR = 1/0.10 = 10. The maximum potential decrease in M1 is the change in reserves multiplied by the multiplier: -10 million × 10 = -$100 million.

Question 7

An individual deposits $10,000 of currency that was previously held at home into a checking account at a commercial bank. If the required reserve ratio is 20%, what is the maximum possible total change in the M1 money supply resulting from this single deposit?

  1. $8,000
  2. $10,000
  3. $40,000 (correct answer)
  4. $50,000
Explanation: The initial deposit of 10,000incurrencydoesnotchangetheM1moneysupply;itonlychangesitscompositionfromcurrencytodemanddeposits.Thebankmusthold2010,000 in currency does not change the M1 money supply; it only changes its composition from currency to demand deposits. The bank must hold 20% of this new deposit (2,000) as required reserves and can lend out the remaining excess reserves of $8,000. This initial loan of $8,000 creates new money. The money multiplier is 1 / 0.20 = 5. The total expansion of new money (through loans being redeposited) is the initial excess reserves multiplied by the money multiplier: $8,000 × 5 = $40,000. This represents the net increase in M1, as the original $10,000 was already part of the money supply.

Question 8

If the required reserve ratio is 10%, the maximum potential increase in the M1 money supply from a $1,000 open market purchase by the central bank is $10,000. Which of the following is a primary reason why the actual increase in the money supply is often less than this maximum potential?

  1. The central bank simultaneously lowers the discount rate, encouraging borrowing.
  2. The seller of the government bond deposits the entire proceeds into a commercial bank.
  3. Commercial banks may choose to hold reserves greater than the required amount. (correct answer)
  4. The velocity of money tends to decrease as the money supply expands.
Explanation: The simple money multiplier (1/RRR) assumes that banks lend out all of their excess reserves and that all loan proceeds are redeposited into the banking system (no currency drain). In reality, these assumptions may not hold. If commercial banks become more cautious or face a lack of creditworthy borrowers, they may choose to hold excess reserves. This action reduces the amount of money lent out in each step of the process, causing the actual money multiplier to be smaller than the potential multiplier.

Question 9

The central bank purchases $50 million of government securities from the public. The seller deposits the funds into a checking account at Bank A. If the required reserve ratio is 20%, what is the maximum amount of new loans the entire banking system can create as a result of this action?

  1. $40 million
  2. $50 million
  3. $200 million (correct answer)
  4. $250 million
Explanation: The central bank's purchase injects 50millionofnewreservesintothebankingsystem.Whenthisisdeposited,BankAmusthold2050 million of new reserves into the banking system. When this is deposited, Bank A must hold 20% (10 million) as required reserves and can lend out the remaining $40 million in excess reserves. This $40 million represents the first round of new loans. The money multiplier is 1/0.20 = 5. The total amount of new loans created by the banking system is the initial excess reserves multiplied by the money multiplier: $40 million × 5 = $200 million. The total change in deposits (and M1) would be 250million,butthequestionspecificallyasksfortheamountofnewloans,whichisthetotalchangeindepositsminustheinitialinjectionofreserves(250 million, but the question specifically asks for the amount of new loans, which is the total change in deposits minus the initial injection of reserves (250M - $50M = $200M).

Question 10

Assume all banks are fully loaned up and the public does not hold any additional currency. The required reserve ratio is 5%. If open market operations cause the M1 money supply to increase by a total of $400 billion, what was the value of the central bank's initial transaction?

  1. $20 billion purchase of securities (correct answer)
  2. $80 billion purchase of securities
  3. $400 billion purchase of securities
  4. $8 trillion purchase of securities
Explanation: This question requires working backward from the total change in the money supply to the initial injection of reserves. First, calculate the money multiplier: Multiplier = 1 / RRR = 1 / 0.05 = 20. The relationship between the change in the money supply and the initial change in reserves is: ΔM1 = Initial ΔReserves × Multiplier. To find the initial change in reserves, rearrange the formula: Initial ΔReserves = ΔM1 / Multiplier. Plugging in the values: Initial ΔReserves = $400 billion / 20 = $20 billion. An increase in reserves is caused by a central bank purchase of securities.

Question 11

The central bank buys $100,000 of bonds from an individual. The required reserve ratio is 10%. The individual deposits 80% of the payment into a checking account and holds the remaining 20% as currency. Assuming all banks lend out their full excess reserves and there are no further currency drains, what is the total increase in the money supply?

  1. $1,000,000
  2. $800,000
  3. $720,000
  4. $820,000 (correct answer)
Explanation: The central bank's action injects $100,000 of new reserves into the economy. Of this, $20,000 is held as currency (a 'currency drain') and $80,000 is deposited in a bank. The $20,000 held as cash is an immediate increase to M1. The $80,000 deposited in the bank increases the banking system's reserves by $80,000. These reserves can support a total amount of deposits equal to Reserves / RRR = $80,000 / 0.10 = $800,000. The total money supply (M1) is the sum of currency held by the public and total demand deposits. Therefore, the total increase in the money supply is the $20,000 in new currency plus the $800,000 in new deposits, for a total of $820,000.

Question 12

The simple deposit expansion multiplier, calculated as 1 divided by the required reserve ratio, will accurately predict the maximum potential change in the money supply only if which key assumptions hold true?

  1. The velocity of money and the price level remain constant during the expansion.
  2. The central bank does not change the discount rate during the expansion process.
  3. The initial change in reserves comes from an open market operation rather than a cash deposit.
  4. The public holds no currency and banks hold no excess reserves. (correct answer)
Explanation: The simple deposit expansion multiplier is a theoretical tool that shows the maximum potential increase in the money supply when new reserves enter the banking system. The formula 1required reserve ratio\frac{1}{\text{required reserve ratio}} assumes perfect conditions where every dollar of new reserves gets fully leveraged through the banking system. For this multiplier to accurately predict the maximum money supply change, two critical assumptions must hold: banks must lend out every dollar they're legally allowed to (holding no excess reserves), and borrowers must redeposit all borrowed funds back into the banking system rather than holding cash. When banks hold excess reserves, they're not lending to their full potential, reducing the actual multiplier effect. When people hold currency outside banks, those dollars exit the deposit expansion process entirely. Answer choice A is incorrect because the velocity of money and price level affect economic activity and inflation, not the mechanical process of deposit creation through fractional reserve banking. Choice B misses the mark because the discount rate influences banks' borrowing costs from the Fed, but doesn't directly affect how deposits multiply through the required reserve mechanism. Choice C is wrong because the multiplier effect works the same regardless of whether new reserves come from open market operations, cash deposits, or other sources—what matters is that new reserves enter the system. When studying money multipliers, remember that theoretical maximums assume perfect conditions. Real-world multipliers are always smaller because banks do hold excess reserves and people do hold cash, creating "leakages" that reduce the actual expansion below the theoretical maximum.

Question 13

A bank has $200 million in demand deposits and $40 million in total reserves. The required reserve ratio is 15%. If the central bank lowers the required reserve ratio to 10%, what is the immediate increase in this bank's excess reserves, and what is the maximum potential increase in the money supply that can be created by the entire banking system from this bank's action?

  1. Excess reserves increase by $10 million; potential M1 increase is $66.7 million.
  2. Excess reserves increase by $10 million; potential M1 increase is $100 million. (correct answer)
  3. Excess reserves increase by $20 million; potential M1 increase is $200 million.
  4. Excess reserves increase by $30 million; potential M1 increase is $150 million.
Explanation: Step 1: Find the initial excess reserves. Initial required reserves = 15% of $200M = $30M. Initial excess reserves = $40M - $30M = $10M. Step 2: Find the new excess reserves. New required reserves = 10% of $200M = $20M. New total excess reserves = $40M - $20M = $20M. Step 3: Find the increase in excess reserves. The increase is $20M - $10M = $10M. This is the amount of new lending the bank can do. Step 4: Calculate the maximum potential increase in the money supply. This is the newly created excess reserves multiplied by the new money multiplier. New multiplier = 1/0.10 = 10. Max M1 increase = $10M × 10 = $100M.

Question 14

The process by which the banking system creates a multiple expansion of the money supply from an initial increase in reserves is often called 'money creation.' Why is this process NOT considered 'wealth creation'?

  1. Because every new monetary asset created for a borrower is matched by a new liability for that borrower. (correct answer)
  2. Because the creation of new money is immediately offset by an equal increase in the price level.
  3. Because the new money is fiat money and not backed by a physical commodity.
  4. Because only the production of real goods and services, not financial instruments, can create wealth.
Explanation: When banks create money through lending, you need to distinguish between creating money and creating wealth. These are fundamentally different economic concepts that students often confuse. The money creation process works when banks receive deposits, keep a fraction as reserves, and lend out the rest. This lending creates new deposit accounts for borrowers, effectively expanding the money supply. However, this doesn't create net wealth because every dollar lent creates both an asset and a liability of equal value. Answer A correctly identifies why this isn't wealth creation: each new monetary asset (the borrower's deposit) is perfectly matched by a new liability (the borrower's debt to the bank). The borrower gains spending power but also owes exactly that amount back with interest. No net wealth is created—only a redistribution of existing wealth through the financial system. Answer B incorrectly assumes immediate inflation offsetting money creation. While excessive money creation can eventually cause inflation, this isn't automatic or immediate, and it's not why money creation differs from wealth creation. Answer C focuses on fiat money versus commodity backing, which is irrelevant to the wealth creation question. The backing of money doesn't determine whether creating it constitutes wealth creation. Answer D is too extreme. While real goods and services are primary wealth creators, financial instruments can facilitate wealth creation and represent claims on real wealth. The issue isn't that financial instruments can't create wealth, but that this specific process creates offsetting assets and liabilities. Remember: money creation involves bookkeeping entries that balance out, while wealth creation requires producing something of genuine value.

Question 15

Initially, the banking system has $100 billion in total reserves and $1,000 billion in demand deposits. The required reserve ratio is 10%, and there are no excess reserves. Then, the public deposits $10 billion of currency it had been holding into checking accounts. What is the maximum amount of new loans the banking system can now create?

  1. $90 billion (correct answer)
  2. $10 billion
  3. $9 billion
  4. $100 billion
Explanation: This question tests your understanding of the money multiplier effect and how new deposits create lending capacity in the banking system. When you see a problem involving deposits and reserve requirements, focus on how much of the new money can be loaned out versus how much must be held as reserves. When the public deposits $10 billion into checking accounts, this money enters the banking system as new reserves. Since the required reserve ratio is 10%, banks must hold $10\% \times \10\text{ billion} = $1\text{ billion} as required reserves. The remaining $10\text{ billion} - $1\text{ billion} = $9\text{ billion} becomes excess reserves that can be loaned out. Here's the key insight: when banks loan out this $9 billion, it gets deposited elsewhere in the system, creating new deposits that generate additional lending capacity. The maximum total new loans equals the initial excess reserves times the money multiplier: $\9\text{ billion} \times \frac{1}{0.10} = $90\text{ billion}$$. Looking at the wrong answers: B) $10 billion incorrectly assumes all the new deposits can be loaned (ignoring reserve requirements). C) $9 billion represents only the first round of lending, missing the multiplier effect entirely. D) $100 billion incorrectly applies the multiplier to the full $10 billion deposit rather than just the excess reserves. Study tip: Remember the formula for maximum new loans: (new excess reserves) × (money multiplier). The multiplier amplifies the initial excess reserves, not the total deposit. Always subtract required reserves first, then multiply.

Question 16

Bank Delta has $80 million in checkable deposits and $15 million in reserves when the required reserve ratio is 18%. The bank's management decides to maintain a cushion of excess reserves equal to 2% of deposits. If a depositor withdraws $3 million in cash, and Bank Delta wants to restore both its required reserves and its desired excess reserves to the target levels, how much must the bank reduce its outstanding loans?

  1. $4.8 million, because the bank needs to account for both the cash withdrawal and reserve requirement changes
  2. $5.4 million, because the withdrawal affects both required and excess reserve calculations proportionally
  3. $6.2 million, because the bank must restore reserves while maintaining its desired cushion policy
  4. $3.6 million, because the withdrawal creates a reserve shortage that requires loan reduction to rectify (correct answer)
Explanation: Initially: $80M deposits, $15M reserves. Required reserves = 18% × $80M = $14.4M. Desired excess reserves = 2% × $80M = $1.6M. Total desired reserves = $14.4M + $1.6M = 16M.Currentreserves(16M. Current reserves (15M) are $1M below target. After $3M withdrawal: deposits = $77M, reserves = $12M. New required reserves = 18% × $77M = $13.86M. New desired excess reserves = 2% × $77M = $1.54M. Total desired reserves = $13.86M + $1.54M = $15.4M. Current reserves are $12M, so shortage = $15.4M - $12M = $3.4M. The bank needs to reduce loans by approximately $3.6M (closest answer) to restore its reserve position. The slight difference may be due to rounding in the calculation.

Question 17

Assume the required reserve ratio is 10% and banks create the maximum amount of loans possible. Which of the following initial events would lead to the largest potential creation of new loans throughout the banking system?

  1. An individual deposits $5,000 of currency from under their mattress into a commercial bank.
  2. The central bank purchases $5,000 of government bonds from a commercial bank. (correct answer)
  3. The central bank purchases $5,000 of government bonds from an individual, who then deposits the full amount.
  4. A customer repays a $5,000 loan to a bank using funds transferred from an account at a different bank.
Explanation: The key is the initial change in excess reserves for the banking system. (B) When the central bank buys bonds from a commercial bank, the bank's reserves increase by $5,000 with no corresponding change in its deposit liabilities. Thus, all $5,000 become excess reserves. Max new loans = $5,000 * (1/0.1) = $50,000. (A) and (C) A $5,000 deposit creates $5,000 in reserves but also $5,000 in new deposits, increasing required reserves by $500. Initial excess reserves are only $4,500. Max new loans = $4,500 * (1/0.1) = $45,000. (D) A transfer of funds between banks changes the reserves of individual banks but does not change the total reserves in the banking system, so no new loans can be created for the system as a whole.

Question 18

Suppose the required reserve ratio is 25%. A person deposits $100,000 of cash into Bank A. Bank A lends out its full excess reserves to a borrower, who then deposits the entire loan amount in Bank B. Bank B then lends out its full excess reserves to another borrower. What is the amount of the loan made by Bank B?

  1. $75,000
  2. $56,250 (correct answer)
  3. $42,187.50
  4. $18,750
Explanation:
  1. Bank A receives a 100,000deposit.Itmusthold25100,000 deposit. It must hold 25% (25,000) as required reserves. It lends out the remaining excess reserves: $100,000 - $25,000 = $75,000. This is the loan from Bank A. 2. The $75,000 loan is deposited into Bank B. Bank B must hold 25% of this new deposit as required reserves: 0.25 × $75,000 = $18,750. 3. Bank B can lend out its excess reserves, which is the deposit amount minus its required reserves: $75,000 - $18,750 = $56,250. This is the loan made by Bank B.

Question 19

A customer withdraws $1,000 in cash from a checking account. Assume the required reserve ratio is 10% and that all banks were initially loaned up with no excess reserves. Which of the following correctly describes the immediate effect on M1 and the maximum potential change in M1 for the entire banking system?

  1. Immediate M1 change is -$1,000; maximum potential M1 decrease is $10,000.
  2. Immediate M1 change is zero; maximum potential M1 decrease is $10,000.
  3. Immediate M1 change is zero; maximum potential M1 decrease is $9,000. (correct answer)
  4. Immediate M1 change is -$1,000; maximum potential M1 decrease is $9,000.
Explanation: The immediate effect on M1 is zero. M1 consists of currency in circulation and demand deposits. The withdrawal increases currency by $1,000 and decreases demand deposits by $1,000, leaving the total unchanged. However, the banking system loses $1,000 in reserves. With a 10% RRR, these reserves were supporting $1,000 / 0.10 = $10,000 in deposits. The banking system must therefore contract deposits by a maximum of 10,000.ThenetchangeinM1isthedecreaseindeposits(−10,000. The net change in M1 is the decrease in deposits (-10,000) offset by the initial increase in currency held by the public (+$1,000), resulting in a maximum potential decrease in M1 of $9,000.

Question 20

Assume banks hold no excess reserves and the public holds no currency. Following a $20 million open market purchase of securities by the central bank from the public, the M1 money supply ultimately increases by a total of $250 million. What must the required reserve ratio be?

  1. 4.0%
  2. 8.0% (correct answer)
  3. 8.7%
  4. 12.5%
Explanation: The relationship between the total change in the money supply (deposits), the initial change in reserves, and the money multiplier is ΔM1 = ΔReserves × (1/RRR). The open market purchase injects $20 million of new reserves into the banking system. The total change in M1 (and deposits, since there is no currency holding) is $250 million. We can find the RRR by rearranging the formula: RRR = ΔReserves / ΔM1. So, RRR = $20 million / $250 million = 0.08, or 8.0%.