Question

Suppose the Federal Reserve decides to increase the interest rate it pays on reserves, causing excess reserves holdings to decrease by $5
billion. If the reserve requirement is 15 percent, how will the money supply change?

Answer 1

When interest rates are increased, money supply would decrease by $33.33 billion.

When the interest rates  are increased, it is known as a contractionary monetary policy. Contractionary monetary policy leads to a decrease in money supply.

Change in money supply =  change in excess reserves x money multiplier

Money multiplier = 1 / reserve requirement

1 / 0.15 = 6.67

Change in money supply = $5 billion x 6.67 = $33.33 billion

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