Unlocking the Magic of Money Multiplier Effect
How does the reserve ratio impact the total change in the Money Supply?
a) $5,000
b) $200,000
c) $2,000,000
d) $500,000
e) $50,000,000
The Total Change in the Money Supply Explained
The total change in the Money Supply, considering the reserve ratio of 5%, would be $2,000,000. This increase is due to the money multiplier effect, which allows the initial injection of new money to have a multiplied impact on the overall money supply.
Have you ever wondered how a small amount of new money injected into the banking system can lead to a significant increase in the overall Money Supply? The answer lies in the concept of the money multiplier effect.
When the central bank transfers $100,000 of new money into the chartered banks, the reserve ratio of 5% plays a crucial role. The reserve ratio determines the portion of deposits that banks must hold in reserves and cannot lend out. In this case, with a reserve ratio of 5%, banks can lend out 95% of the new deposits.
The money multiplier formula helps us understand how this initial injection of new money creates a ripple effect on the Money Supply. The formula is given as follows: Money Multiplier = 1 / Reserve Ratio.
With a reserve ratio of 5%, the money multiplier is calculated as 1 / 0.05 = 20. This means that every dollar of new money injected into the system can result in $20 of new loans and cash deposits.
By multiplying the initial injection of $100,000 by the money multiplier of 20, we find that the total change in the Money Supply amounts to $2,000,000. This significant increase showcases the power of the money multiplier effect in expanding the Money Supply beyond the initial injection.
Understanding the dynamics of the money multiplier effect is essential in comprehending how central bank actions impact the broader economy. It illustrates how a seemingly modest injection of new money can lead to substantial changes in the Money Supply, influencing economic growth and stability.
Next time you hear about the central bank injecting new money into the banking system, remember the magic of the money multiplier effect at play, transforming a small push into a tidal wave of financial activity.