Question

Bank of Tropico has, in the past, always operated with a reserve ratio of 25%. However, Bank of Tropico is being acquired by Winter Bank, which operates with a reserve ratio of 12.59 Assuming that Bank of Tropico adopts the reserve ratio of its new owner, what will be the effect on money supply in the economy due to this acquisition? O Money supply will be unchanged because the central bank has made no policy changes. 0 The effect on money supply cannot be determined from the information given. O Money supply will decrease because the loans will have to be repaid. O Money supply will increase because Bank of Tropico will increase its loans.

Answer 1

Answer : Option d) Money supply will increase since Bank of Topico will increase its loans

Previously the Bank of Tropico operated with a reserve ratio of 25% and now after being acquired by Winter Bank it will operate with a lower reserve ratio that is 12.5%. Now reserves are a fraction of deposits that the banks keep with themselves in order to ensure smooth functioning of the daily banking activities.

When the reserve ratio gets lowered from 25% to 12.5% what happens is that a fraction of money (25% - 12.5% = 12.5%) gets out of the reserves which can then be lended. Thus in a sense Bank of Tropico can increase its loans and thereby increase money supply by injecting money into the economy in the form of loans.