The banking system has $20 million in reserves and has a reserve requirement of 20 percent. Bankers previously did not hold any excess reserves, but difficult economic times make them decide that it is prudent to hold 25 percent of deposits as reserves. Other things equal, by how much must the Bank of Canada increase bank reserves to keep the money supply the same?
A)$4 million
B)$5 million
C)$20 million
D)No action by the Bank of Canada is necessary.

Question

Quizplus · Accepted Answer

The initial total deposits are $100 million ($20 million in reserves divided by a reserve requirement of 20%).

With the decision to hold 25% of deposits as reserves, the new required reserves will be $25 million (25% of $100 million in deposits).

The current reserves of $20 million are only sufficient to cover the old reserve requirement of 20%. Therefore, the bank needs to increase its reserves by $5 million ($25 million - $20 million) to meet the new reserve requirement.

As a result, the Bank of Canada needs to increase bank reserves by $5 million to keep the money supply the same.

The Banking System Has $20 Million in Reserves and Has