At one time,the country of Sylvania 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 Sylvania now keep half their money in the form of currency and half in the form of bank deposits.If banks do not hold excess reserves,how much currency do the people of Sylvania now hold?
A) $2 million
B) $5 million
C) $9 million
D) $12 million

Question

Quizplus · Accepted Answer

Before the banking system was established, the total currency in circulation was $10 million. Once the banking system is established with a reserve requirement of 20%, the initial deposit received by the bank will be $8 million ($10 million x 80%). The people of Sylvania keep half their money in the form of currency and half in the form of bank deposits, which means $5 million of the initial currency will be deposited in the bank. Therefore, there will be $5 million in currency and $8 million in deposits. However, this does not account for the additional money that will be created through the banking system's expansionary effect. When the bank lends out their deposits, it creates new money in the economy, which can be reinvested or kept in circulation. The money multiplier formula is 1/reserve requirement, and since the reserve requirement is 20%, the money multiplier is 5. This means that the $8 million in deposits can potentially create $40 million in new money. If half of this new money is kept in the form of currency, that means the people of Sylvania now hold a total of $25 million in currency ($5 million initial + $20 million from bank expansion). Therefore, the people of Sylvania now hold $9 million in currency and not $5 million.

At One Time,the Country of Sylvania Had No Banks,but Had