Suppose a bank uses $200 of its $500 excess reserves to make a new loan when the reserve ratio is 20 percent. How does this action by itself initially change the money supply?
A) The money supply increases by $40.
B) The money supply decreases by $40.
C) The money supply increases by $200.
D) The money supply decreases by $200.

Question

Quizplus · Accepted Answer

By making a new loan of $200, the bank has increased the amount of money in circulation in the economy. The initial effect is that the money supply increases by the same amount as the loan, which is $200. This is because the bank has created new money by lending out some of its excess reserves. Since the reserve ratio is 20 percent, the bank is required to hold $40 ($200 x 0.20) as reserves and can lend out $160 ($200 - $40) to a borrower. This $160 is new money that didn't exist before, so the overall money supply has increased by $200.

Suppose a Bank Uses $200 of Its $500 Excess Reserves