Bank Reserves and the Money Supply: The Impact of Excess Reserves

How does holding excess reserves affect the money supply?

Choose one: (A) The money supply will increase as banks loan out more money. (B) The money supply will increase as banks hold more vault cash. (C) The money supply will increase as a bank’s vault cash falls. (D) The money supply will decrease as banks loan out less money. (E) There is no impact. The level of deposits and loans will be unaffected.

Final Answer:

Excess reserves held by a bank decrease the money supply because this money is not being loaned out to stimulate economic activity. Therefore, the money supply will decrease as banks loan out less money.

When a bank holds excess reserves, it means it is retaining more money than it is legally obligated to. This action directly impacts the money supply in the economy. The correct answer is (D) The money supply will decrease as banks loan out less money.

Here's why: Banks loan out their reserves to borrowers, and these loans enter the economy as new money, which increases the money supply. When banks hold back some of their reserves, they reduce the amount of loans they can make, which in effect decreases the potential money supply. Instead of being used for loans that could stimulate economic activity, these funds are being held back, thus effectively reducing the total money supply.