If the reserve requirement is 20%, then a $1 decrease in deposits means that the money supply
A) will increase by $5.
B) has the potential to increase by $20.
C) will decrease by $5.
D) has the potential to decrease by $5.

Question

Quizplus · Accepted Answer

If the reserve requirement is 20%, it means that banks are required to hold 20% of their deposits as reserves and can only loan out the remaining 80%. So, if there is a $1 decrease in deposits, banks have $0.80 less to loan out. However, since the reserve requirement is still 20%, they need to hold on to $0.20 of that $0.80 as reserves, leaving only $0.60 to be loaned out. This has the potential to decrease the money supply by $0.60, which is the amount of the deposit that was not loaned out. However, this decrease in the money supply depends on whether or not the borrower of the new loan deposits the money back into the banking system, which could potentially increase the money supply again. Thus, the correct answer is D, as there is the potential for a $5 decrease in the money supply, but it is not guaranteed.

If the Reserve Requirement Is 20%, Then a $1 Decrease