An economy's monetary base is $500 billion, and the reserve-deposit ratio is 0.2. Suppose people hold one-fourths of their money as currency and deposit three-fourths at banks. Then what are the currency-deposit ratio and money supply?
Question
An economy's monetary base is $500 billion, and the reserve-deposit ratio is 0.2. Suppose people hold one-fourths of their money as currency and deposit three-fourths at banks. Then what are the currency-deposit ratio and money supply?
Solution
The currency-deposit ratio is the proportion of total money that people hold as currency. If people hold one-fourths of their money as currency and deposit three-fourths at banks, then the currency-deposit ratio is 1/3 (one-fourth divided by three-fourths).
The money supply in an economy can be calculated using the money multiplier formula:
Money Supply = Monetary Base * Money Multiplier
The money multiplier is given by the formula:
Money Multiplier = 1 + Currency-Deposit Ratio / Reserve-Deposit Ratio + Currency-Deposit Ratio
Substituting the given values into the formula:
Money Multiplier = 1 + 1/3 / 0.2 + 1/3 Money Multiplier = 1 + 1.67 Money Multiplier = 2.67
Then, substituting the values of the monetary base and the money multiplier into the money supply formula:
Money Supply = 1335 billion
So, the currency-deposit ratio is 1/3 and the money supply is $1335 billion.
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