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Brief Principles of Macroeconomics...

8th Edition
N. Gregory Mankiw
ISBN: 9781337091985

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BuyFindarrow_forward

Brief Principles of Macroeconomics...

8th Edition
N. Gregory Mankiw
ISBN: 9781337091985
Textbook Problem

In a system of fractional-reserve banking, even without any action by the central bank, the money supply declines if households choose to hold ______ currency or if banks choose to hold ________ excess reserves.

a. more, more

b. more, less

c. less, more

d. less, less

To determine

The impact of the behavior of banks and people in fractional reserve banking.

Explanation

The fractional reserve banking system is a system in which the banks accept the deposits from the public and make loans to the public from the deposits, along with keeping a specified fraction of the deposits as reserves.

Option (a):

When the people decide to hold more cash in their hand, the cash with the banks will reduce because the cash in hand will not increase the money supply. Only when the cash is being deposited with the bank will the money supply increase. Similarly, when the bank decides to hold more reserves, they will reduce the loanable fund with them, which is the money supply. Thus, when both the agents decide to hold more with them, the money supply will automatically reduce, without the intervention of the central bank. So, option ‘a’ is correct.

Option (b):

When the people decide to hold more cash in their hand, the cash with the banks will reduce because the cash in hand will not increase the money supply. Only when the cash is being deposited with the bank will the money supply increase. However, when the bank decides to hold less money with the reserve, they will increase the loanable fund with the bank and this increases the credit creation capacity of the banks, which increases the money supply...

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