Suppose a bank uses $100 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 $80.
B)The money supply decreases by $80.
C)The money supply increases by $100.
D)The money supply decreases by $100.

Question

Quizplus · Accepted Answer

When the bank uses $100 of its $500 excess reserves to make a new loan, the money supply increases by $100. This is because the new loan results in an increase in the amount of money in circulation. The reserve requirement is 20 percent, meaning that the bank must hold $20 as reserves for every $100 loaned out. Therefore, the bank will keep $20 of the $100 and lend out $80. This $80 will then be deposited into another bank account, which will, in turn, lend out $64, and so on, until the initial increase in the money supply has multiplied to a larger amount. This process is known as the money multiplier effect.

Suppose a Bank Uses $100 of Its $500 Excess Reserves