When the Fed decreases the interest rate paid on reserves, if the ratio of currency to deposits decreases also while the monetary base is constant, then:
A) it cannot be determined whether the money supply increases or decreases.
B) the money supply increases.
C) the money supply decreases.
D) the two changes exactly offset each other.

Question

Quizplus · Accepted Answer

When the Fed decreases the interest rate paid on reserves, banks are incentivized to lend more rather than hold onto reserves, potentially increasing the money supply. Additionally, if the ratio of currency to deposits decreases, it implies that more money is being held in the form of deposits rather than currency. Since deposits can be multiplied through the banking system via loans (due to the fractional reserve banking system), this also tends to increase the money supply. Together, these actions suggest an increase in the money supply, assuming the monetary base remains constant.

When the Fed Decreases the Interest Rate Paid on Reserves