Understanding the Impact of Currency-to-Bank Deposit Ratio on Monetary Base and Money Multiplier

How does an increase in the currency-to-bank deposit ratio affect the monetary base and money multiplier?

If the currency-to-bank deposit ratio increases and everything else held constant, then it will cause the monetary base to _____ and the money multiplier to _____.

Select one:

A. decrease; decrease

B. increase; remain unchanged

C. remain unchanged; decrease

D. decrease; remain unchanged

E. remain unchanged; remain unchanged

F. remain unchanged; increase

G. decrease; increase

H. increase; decrease

I. increase; increase

Answer:

Option D: decrease; remain unchanged

When the currency-to-bank deposit ratio increases, it means that people are holding a larger proportion of their money in the form of currency (cash) rather than depositing it in banks. As a result, the amount of currency in circulation increases relative to bank deposits.

The monetary base (MB) is composed of currency in circulation (C) and bank reserves (R). Since the currency component of the monetary base increases (due to the increased currency-to-bank deposit ratio), while the bank reserves remain unchanged, the overall monetary base (MB = C + R) will decrease.

On the other hand, the money multiplier remains unchanged because it is determined by the reserve requirement ratio and the currency-to-deposit ratio. If the reserve requirement ratio and the currency-to-deposit ratio do not change, the money multiplier will remain the same.

So, the correct answer is option D.

Understanding the relationship between the currency-to-bank deposit ratio, monetary base, and money multiplier is crucial in analyzing the impact of changes in individuals' preferences for holding cash versus bank deposits. By grasping these concepts, economists and policymakers can make informed decisions to manage and stabilize the financial system.