A bank has excess reserves of $1 million and makes a new loan for $500,000. If the bank faces a 10% required reserve ratio, by how much could the money supply increase when the loan is made

With a 10% required reserve ratio, the money supply could increase by $500,000/r when the loan is made.

This equals $5,000,000 ($500,000/0.1) where r = 10%

Explanation:

a) The money multiplier is the amount of money that banks generate with each dollar of reserves. Reserves is the amount of deposits that the Federal Reserve requires banks to hold and not lend.

b) The formula for the money multiplier is simply 1/r, where r = the reserve ratio.

c) The reserve ratio, also known as Cash Reserve Ratio, is the percentage of deposits which commercial banks are required to keep as cash according to the directions of the central bank.  It is used by the central bank to control the supply of money in the economy.  When the central bank wants to increase the money supply, it lowers the reserve ratio and vice versa.

d) According to wikipedia.com, "the money supply is the total value of money available in an economy at a point of time."  It is usually defined as currency in circulation plus demand deposits.  It is the demand deposits that give commercial banks the ability to create money using the reserve ratio.

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