Money supply

Shimmy!

In Econland all €15,000,000 in currency is held by banks as reserves. The public does not hold any currency. If the banks' desired reserve/deposit ratio is 5%, the money supply in Econland equals?

could anyone please help me with this problem... an explanation would be great thanks!

Économiste Monétaire

€15m/0.05 = €300m. Basically, just put the reserves over the reserve-deposit ratio to get the money supply.

Flamed Diving

Shimmy, basically when a bank receives a deposit it doesn't just hold the money for you in a safe until you return, it generally lends or invests the money. However, regulators say that banks should hold a minimum of that money, just in case more people than expected come looking for their cash only to find there is none. This is called the minimum reserve ratio, which in this case above is 5%. Therefore, every time someone deposits €100, the bank must keep €5 "in the safe".

In your example, the banks initially hold all the money, so they will lend/invest 95% of it and will keep 5%, or €300m.

Slippers

Since the question has been answered, I'd like to explore implications.

In this scenario the government of Econland got to spend €15m before it had to start taxing or borrowing. Why not just have a 100% reserve requirement and spend the other €285m as well? They might not need to tax or borrow at all. The money supply would be €300m either way so no extra inflation risk, right?

It might be harder for banks to make loans because they would have to make them using previous profits, money from investors or borrowings from savers. However, the other €285m would already be in people's accounts so it's as if they were lent it, like in the first scenario, only they have €285m less debt this time.

Edit: Shimmy, this short extract from an old textbook is the clearest explanation of the money supply that I have found (feel free to ignore the rest of the stuff on the page).