Assume that banks do not hold excess reserves. The banking system has $50 million in reserves and has a reserve requirement of 10 percent. The public holds $20 million in currency. Then the public decides to withdraw $5 million in currency from the banking system. If the Bank of Canada wants to keep the money supply stable by changing the reserve requirement, then what will the new reserve requirement be?
A) 8.1 percent
B) 9.1 percent
C) 9.7 percent
D) 10 percent

Question

Quizplus · Accepted Answer

Initially, the banking system has $50 million in reserves and a reserve requirement of 10 percent. The public holds $20 million in currency. Therefore, the total money supply in the economy is:

Money supply = Currency held by the public/Reserve ratio
= $20 million/10%
= $200 million

When the public decides to withdraw $5 million in currency, the reserves of the banking system decrease by $5 million, and the currency held by the public increases to $25 million. Therefore, the money supply decreases to:

Money supply = Currency held by the public/Reserve ratio
= $25 million/10%
= $250 million

To keep the money supply stable, the Bank of Canada can decrease the reserve requirement. Let the new reserve requirement be r. Then, the new money supply will be:

$250 million = Currency held by the public/r

r = Currency held by the public/Money supply
= $25 million/$250 million
= 0.1 or 10%

Therefore, to maintain the money supply, the Bank of Canada needs to decrease the reserve requirement from 10% to:

New reserve requirement = 10% - 0.9%
= 9.1%

Hence, the correct answer is B) 9.1 percent.

Assume That Banks Do Not Hold Excess Reserves