SIE practice questionmediumReserve Requirements
If the Federal Reserve INCREASES reserve requirements for banks, what is the expected effect on the money supply?
- AThe money supply decreases because banks must hold more reserves and can lend less✓ Correct answer
- BThe money supply is unaffected by reserve requirements
- CThe money supply increases because banks have more reserves
- DThe money supply increases because higher reserves encourage more lending
Explanation
Why A — The money supply decreases because banks must hold more reserves and can lend less
When the Fed increases reserve requirements, banks must hold a larger percentage of their deposits in reserve and have less money available to lend. Since bank lending creates new money through the money multiplier effect, reducing lending capacity decreases the money supply (contractionary). Conversely, lowering reserve requirements allows banks to lend more, expanding the money supply. This is a rarely used but important monetary policy tool.
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