What would be the effect of increasing the banks' reserve requirements on the money supply?

Reserve requirements are the percentage of deposits that banks must hold as reserves in their vaults or as deposits at the central bank. In other words, it's the minimum amount of a bank's liabilities (deposits) that they are required to keep on hand at all times. This helps to maintain financial stability and prevent bank runs. Reserve requirements can be either legally mandated by the central bank or set as policy benchmarks in practice.

The money multiplier is a measure of how much new money commercial banks can create through their lending activities given the required reserve ratio. It's the inverse of the reserve requirement. If the reserve requirement is \(r\), then the money multiplier is given by \(1 / r\). The higher the reserve requirement, the lower will be the money multiplier and vice versa.

Increasing reserve requirements will have the following effects on the money supply: a. The money multiplier decreases: As mentioned earlier, an increase in reserve requirements leads to a decrease in the money multiplier. Hence, the amount of new money that commercial banks can create through lending activities will reduce. b. Lending capacity reduction: As banks would be required to maintain a higher proportion of their deposits as reserves, the amount of money they have available to lend out decreases. This decrease in lending capacity directly affects the amount of credit available in the economy. c. Contraction in the money supply: Since the money multiplier is negatively affected and there is a reduction in lending capacity, the overall money supply is likely to contract. In turn, this contraction in money supply can lead to less spending in the economy and potentially slower economic growth. d. Effect on interest rates: An increase in reserve requirements reduces the amount of money available for lending, leading to a potential increase in interest rates. This can make it more difficult for businesses and individuals to access credit, which can also negatively affect economic growth. In conclusion, increasing bank reserve requirements leads to a decrease in the money multiplier, reduced lending capacity, contraction in the money supply, and potentially higher interest rates. The effect on the economy could be slower growth due to reduced credit availability.