The people in an economy have $10 million in money. There is only one bank that all the people deposit their money in and it holds 5% of the deposits as reserves. What is the money multiplier in this economy? Question 24 options: a) 1 b) 5 c) 20 d) 10
The correct answer and explanation is:
The correct answer is d) 10.
Explanation:
The money multiplier is a concept in banking and economics that refers to the amount of money the banking system can create with an initial deposit, given a reserve requirement. The formula for calculating the money multiplier is: Money Multiplier=1Reserve Ratio\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}
Where the reserve ratio is the fraction of deposits that the bank must hold as reserves and not lend out. In this case, the reserve ratio is given as 5%, or 0.05 in decimal form.
So, applying the formula: Money Multiplier=10.05=20\text{Money Multiplier} = \frac{1}{0.05} = 20
Therefore, the money multiplier in this economy would be 20. This means that for every $1 deposited into the bank, the banking system can create up to $20 in total money supply after accounting for the money the bank must keep in reserve.
The process works through the bank lending out a portion of the deposits to borrowers, who in turn may deposit the money into other accounts. The cycle continues, creating more money in the economy as the deposits are re-lent, while the bank keeps only 5% of each deposit as reserves. The higher the reserve requirement, the smaller the money multiplier, and vice versa.