At one time, the country of Aquilonia had no banks, but had currency of $1 million. Then a banking system was established with a reserve requirement of 20 percent. The people of Aquilonia deposited half of their currency into the banking system. If banks do not hold excess reserves, what is Aquilonia's money supply now?

Question

Quizplus · Accepted Answer

With a reserve requirement of 20%, banks can lend out 80% of their deposits. The people of Aquilonia deposited $500,000 (half of their $1 million currency) into the banks. These banks can then lend out 80% of $500,000, which is $400,000. This process of lending and redepositing can continue until the total increase in the money supply is $2 million (the initial $500,000 deposit multiplied by the money multiplier of 4, which is 1 divided by the reserve requirement of 0.20). Therefore, the new money supply is the original $1 million plus the increase of $2 million, totaling $3 million.

At One Time, the Country of Aquilonia Had No Banks