How Excess Reserves Affect the Money Supply
How does holding excess reserves affect the money supply?
Choose one:
A. The money supply will increase as banks hold more vault cash.
B. The money supply will increase as banks loan out more money.
C. There is no impact. The level of deposits and loans will be unaffected.
D. The money supply will decrease as banks loan out less money.
E. The money supply will increase as a bank’s vault cash falls.
Answer: D. The money supply will decrease as banks loan out less money.
Money Supply is created by commercial banks through the 'process of credit creation'. Commercial banks create final deposits many times initial deposits by 'money multiplier'.
The process starts with a person depositing money, for example, $100 in a bank. The banks retain reserves, let's say 20% equals $20, and loan out the remaining amount, $80. The person who borrowed the $80 will then spend it, which becomes another person's income. This cycle continues, with part of the deposited amount being retained as reserves and the rest being loaned out.
This deposit multiplying effect keeps on occurring until the final deposits reach a certain level based on the reserve ratio. The higher the reserve ratio, the lesser the money supply creation by the banks, and vice versa.
Therefore, when banks hold excess reserves, it reduces their capability to lend out money, consequently decreasing the money supply. This is because less money is being loaned out and circulated in the economy.