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True or False: During the Great Depression, the excess reserve to deposit ratio rose...

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lilylee | Student, College Freshman | Salutatorian

Posted July 2, 2013 at 1:13 PM via web

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True or False: During the Great Depression, the excess reserve to deposit ratio rose for a variety reasons. The impact on the money multiplier was negative. That is, all else constant, a higher excess reserve to deposit ratio lowers the money multiplier.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted July 2, 2013 at 1:29 PM (Answer #1)

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This statement is true.  When a higher percentage of bank deposits is held by the banks as excess reserves, the value of the money multiplier decreases.  In order to see why this is so, let us first look at the formula for the money multiplier.

The formula for the money multiplier is

Multiplier = 1 / required reserve ratio.

We must note, however, that this assumes that banks will loan out all of the deposits that they are not required to keep as required reserves.  In essence, the divisor in this formula is really the percent of deposits that is being kept in the bank rather than being loaned out.  When excess reserves rise, the divisor in this formula rises as well.  When this happens, the multiplier drops.

We can also see why the value of the money multiplier drops in a non-mathematical way.  The multiplier exists because banks loan money.  If I deposit $1000, the bank might keep $100 as required reserves and loan the other $900 to someone else.  When they make this loan, the money supply has increased by $900 because my $1000 has become $1900.  Now imagine that the bank holds excess reserves.  Now, I deposit $1000 but the bank keeps $500.  In this case, my $1000 only becomes $1500.  Thus, when banks keep more money in reserves, the value of the money multiplier decreases.

For these reasons, the statement is true.

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