Question

If the Fed simultaneously reduces the discount rate and the required reserve ratio, the money supply will:
A. contract.
B. remain unchanged.
C. expand.
D. take on a value that cannot be determined from the information given.

Answer 1

Answer:

C) expand.

Explanation:

The discount rate is  the interest rate on loans from the Fed to private banks, if the discount rate falls, then the demand for  excess reserves rises because they have a lower cost. Given this situation plus a reduction in the required reserve ratio (which forces banks to keep a certain fraction of their deposits in accounts), then the money supply should expand.

Banks will have more money to loan, therefore they will "create" more money. Banks create money when a customer makes a deposit, and the bank loans this customer's money to other clients, multiplying the amount of money available.

Client A deposits $100 in bank X, then bank X loans $90 to client B, then client B buys goods form client C who deposits the $70 in bank Y, then bank Y loans $65 to client D, and so on.