Money Multiplier and Deposit Ratio: Understanding the Relationship
What happens when the currency-to-bank deposit ratio increases?
A. increase; remain unchanged
B. decrease; decrease
C. remain unchanged; increase
D. decrease; increase
E. remain unchanged; remain unchanged
F. increase; decrease
G. increase; increase
H. decrease; remain unchanged
I. remain unchanged; decrease
Answer:
The correct answer is F: increase; decrease. When the currency-to-bank deposit ratio increases, it means that people are holding a larger proportion of their money in the form of currency rather than depositing it in banks.
This reduction in the amount of money available for banks to lend out and create new deposits through the money multiplier process ultimately leads to a decrease in the money supply. The money multiplier concept is crucial for understanding how initial bank deposits can result in a larger amount of money circulating in the economy.
The money multiplier depends on the reserve requirements established by the central bank and individuals' tendency to hold currency versus depositing funds in banks. When the currency-to-bank deposit ratio rises, indicating a preference for holding currency, the ability of banks to generate new deposits and expand the money supply diminishes.
It's worth noting that this explanation assumes that all other factors remain constant. In reality, changes in the money supply can have ripple effects on various economic variables like interest rates, investment, and consumption, potentially leading to further alterations in the money supply.