CE 08-10

The government may reduce the money supply to cool down the overheated economy. The balance sheet of the banking system is as follows:

Suppose the public in this economy always holds the same amount of cash and the banking system never holds excess reserves. The central bank increases the minimum reserve ratio of this banks by 5%.

(a) Explain briefly the process of deposit contraction resulting from the above change in the reserve ratio. (4 marks)

(b) Calculate and explain the change in money supply in the economy resulting from the above deposit contraction. (5 marks)