At one time, the country of Aquilonia had no banks, but had currency of $10 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

When half of the $10 million currency is deposited, $5 million is in banks. With a 20% reserve requirement, banks can lend out 80% of $5 million, which is $4 million. This $4 million can be redeposited and re-lent, creating a money multiplier effect. The money multiplier is 1/0.2 = 5. Thus, the total money supply is the initial $5 million in currency plus $5 million in deposits multiplied by the money multiplier, resulting in $25 million in deposits. Adding the remaining $5 million in currency outside banks, the total money supply is $30 million.

At One Time, the Country of Aquilonia Had No Banks