If the reserve requirement is 25%, then a $1 increase in deposits means that the money supply
A) will increase by $4.
B) has the potential to increase by $4.
C) will increase by $25.
D) has the potential to increase by $25.

Question

Quizplus · Accepted Answer

A reserve requirement of 25% means that banks must keep 25 cents of every dollar deposited as reserves and can lend out the rest. Therefore, a $1 increase in deposits has the potential to generate $4 of money supply ($1/.25 = $4). However, whether or not this actually happens depends on whether or not the banks decide to lend out the additional $0.75. So the correct answer is B, which acknowledges that the increase in deposits has the potential to increase the money supply by $4, but doesn't make the assumption that it will definitely happen.

If the Reserve Requirement Is 25%, Then a $1 Increase