Trade Reserve
How to reduce a money supply of $1 Trillion by $100 Billion if the required reserve ratio is .05?
Suppose that the money supply is $1 trillion. Decision makers at the Fed decide that they wish to reduce the money supply by $100 billion, or by 10%. If the RRR is 0.05, what does the Fed need to do to carry out the planned reduction? (Suppose the Fed can trade bond in the market)
Total increase in money supply = Initial injection / Reserve Rate.
Going by this formula, 0.05 is basically a 20x multiplier for each dollar injected into the economy. Solve the simple algebra to determine that $5 billion reduction will work its way into $100 billion. The RR implies that all the banks are required to hold 5% of their total deposits ready for withdrawal, and the other 95% can be loaned out, which in turn will be deposited with other banks and loaned out further, giving a multiplier effect.
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