<p>Im taking a practice test and Im not quite understanding this question. A little help would be great. so the question is: </p>
<p>The potential amount of money created after the Fed increases bank reserves will be diminished if
A) the public prefers to hold less cash
B) the velocity of money falls
C) depository institutions decide to hold more excess reserves
D) the marginal propensity to consume falls
E) the international value of the dollar falls</p>
<p>The answer is C… but im not sure why. I thought that by increasing the bank reserves, the supply of money decreases…therefore decreasing the interest rate and lowering demand. if the institutions decide to hold more excess reserves, wont that also decrease the money supply?
im confused.
by the way i am self studying for the exam, so the more thorough the explanation, the better.</p>
<p>you’re confusing bank reserves with required reserves. in this context bank reserves just means amount of money i think. the potential amount of money will be diminished…if banks(depository institutions) decide to hold more excess reserves because its not being loaned to the public.</p>
<p>i kind of get what you are saying but i thought bank reserves was required reserves…such a weird question.</p>
<p>This question just doesn’t make sense.</p>
<p>Every bank has a required amount of money that they have to hold which is regulated by the government. This money amount is called the “required reserve”. Any additional money the bank chooses to hold is considered as “excess reserve”. When banks loan, they loan out the money that they aren’t going to hold onto. If they hold onto more, then they cannot loan out as much and therefore cannot create as much money.</p>
<p>For example, say the required reserve ratio is 20% and the bank has $100. The bank would be forced to hold $100 * 0.2 = $20 and could loan out the other $80. However, if they decide to hold more reserves for whatever reason, that extra amount is considered “excess reserves”. If they chose to hold $30 in total ($20 required + $10 excess), then they could only loan out $70, meaning they cannot create as much money through loaning.</p>
<p>Ya but the fed was trying to decrease the money supply anyways…?</p>
<p>What? If the Fed decreases the money supply, banks will have less money to lend out to other banks.</p>
<p>And here is why the answer is C: If banks hold on to more of their excess reserves (reserves that they are not required to hold in their vault or with the fed), the potential amount of money created by the Fed action is diminished because banks are choosing to loan LESS to other banks. </p>
<p>Money creation is dependent upon banks loaning to other banks - this is where the money multiplier comes in and how the system can expand well beyond the Fed’s initial money dump.</p>
<p>It’s a pretty poor question but all you have to know is that money <em>creation</em> is only affected by actions taken by the fed, and the amount of reserves kept by banks. Choice C is the only one that involves reserve quantities, and the higher that quantity the less money is loaned, the less money can be created.</p>
<p>I think they were assuming all banks have excess reserves, and thus if the “Fed increases bank reserves,” i.e. required reserves, banks can choose to keep their reserves the same by moving some excess reserves to required reserves or keep their excess reserves the same by increasing them the same amount required reserves increased by. If they opt for the latter, total reserves goes up and as the money multiplier (for money creation) is 1/R, this decreases the amount of money potentially created.</p>
<p>That’s about as thorough as I can get.</p>