Suppose a country's reserve-deposit ratio (cr) decreases and its monetary base (B) remains constant.Briefly answer the following questions.a. What is the impact on the money multiplier (m)? (1 mark)b. What is the impact on the money supply (M)? (1 mark)c. Suggest one policy the country's central bank can implement to counter the impact of the reserve-deposit ratio change on money supply. The suggested policy must change the country's monetary base (B).
Question
Suppose a country's reserve-deposit ratio (cr) decreases and its monetary base (B) remains constant.Briefly answer the following questions.a. What is the impact on the money multiplier (m)? (1 mark)b. What is the impact on the money supply (M)? (1 mark)c. Suggest one policy the country's central bank can implement to counter the impact of the reserve-deposit ratio change on money supply. The suggested policy must change the country's monetary base (B).
Solution
a. The money multiplier (m) is calculated as 1/cr, where cr is the reserve-deposit ratio. If cr decreases and everything else remains constant, the money multiplier (m) will increase. This is because the money multiplier is inversely related to the reserve-deposit ratio.
b. The money supply (M) is calculated as m*B, where m is the money multiplier and B is the monetary base. If the money multiplier increases and the monetary base remains constant, the money supply will increase. This is because the money supply is directly related to the money multiplier.
c. To counter the impact of the decrease in the reserve-deposit ratio on the money supply, the central bank could decrease the monetary base (B). This could be done by selling government bonds in open market operations, which would reduce the amount of reserves in the banking system and hence decrease the monetary base. This would offset the increase in the money supply caused by the decrease in the reserve-deposit ratio.
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