Assume that all commercial banks are making their maximum amount of loans possible. Total deposits in the banking system are £200 million. The liquidity ratio is increased from 20% to 25%. The money supply will

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When the liquidity ratio increases from 20% to 25%, banks are required to hold a larger fraction of deposits as reserves and can lend out less. Initially, with a 20% reserve ratio, banks could lend out 80% of deposits. When the ratio increases to 25%, they can only lend out 75% of deposits. This reduction in lending capacity decreases the money supply through the money multiplier effect. The decrease can be calculated as follows: With a 20% reserve ratio, the maximum money supply is £200 million / 0.20 = £1 billion. With a 25% reserve ratio, the maximum money supply is £200 million / 0.25 = £800 million. The difference is £200 million - £800 million = £-600 million in the potential maximum money supply, but the immediate effect on the existing money supply involves recalculating the change in lending capacity: £200 million * (0.80 - 0.75) = £200 million * 0.05 = £10 million. However, the correct interpretation involves understanding the broader impact on the money supply through the multiplier, not just the immediate change in lending capacity. The error in calculation here points to a misunderstanding of the direct impact versus the overall effect on the money supply. The correct approach to determine the specific decrease involves understanding that the initial and new reserve ratios affect the overall lending and thus the money supply. The decrease is not directly £40 million as initially calculated but is influenced by how the change in reserve requirements affects the banking system's ability to create money through lending. The calculation error led to confusion in the explanation. The correct understanding is that changing the reserve ratio affects the money supply by altering banks' ability to lend, but the specific impact needs to be calculated based on the banking system's structure and the money multiplier effect.

Assume That All Commercial Banks Are Making Their Maximum Amount