Assume that the Paris First National Bank's loan position contracted from $16 million to $12 million. If the required reserve ratio was increased from 20 percent to 40 percent, how much would the money supply shrink?

Question

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The initial loan of $16 million created $4 million in reserves ($16 million x 0.20). When the loan position contracts to $12 million, there would still only be $4 million in reserves. However, with a required reserve ratio of 40 percent, the bank would need to hold $4.8 million in reserves ($12 million x 0.40). Therefore, the bank would need to reduce its lending by $800,000 ($4.8 million - $4 million) in order to meet the new reserve requirement. This reduction in lending would lead to a shrinkage in the money supply of $20 million ($800,000 ÷ 0.04).

Assume That the Paris First National Bank's Loan Position Contracted