Banks Hoard Reserves
The question
Commercial banks in the country of Halvorn tighten their internal lending standards and begin holding a much larger share of their deposits as reserves instead of making new loans. The central bank of Halvorn has not changed the reserve requirement, the discount rate, or its holdings of bonds, and the price level and real income are unchanged. Show the effect on the money market. Show the effect on the Money Market graph.
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Banks Hoard Reserves: the worked answer
On the Money Market graph, Money supply (MS) shifts left.
Why Money supply (MS) shifts left
New bank loans create new deposits, and deposits are part of the money supply, so the volume of lending determines how much money the banking system builds on top of the reserves the central bank has supplied. When banks sit on excess reserves rather than lending them, less of the money multiplier actually operates, so the total quantity of money is smaller at every interest rate and the vertical MS line shifts to the left. The price level and real income are held constant and nothing has changed about how people make payments, so money demand does not move.
What happens to the equilibrium
The equilibrium nominal interest rate rises as the quantity of money in the economy decreases.
The mistake students make on this one
The wrong answer students give here is "nothing shifts, because only the central bank can move MS," since the stem says no policy tool was used. The central bank supplies reserves, but banks' lending decisions determine how much deposit money is created from those reserves, so hoarding excess reserves shrinks the money supply even with every policy setting untouched.
On exam day
Excess reserves are the classic leak in the money multiplier: when a stem says banks choose to sit on reserves rather than lend, shift MS left even though the central bank did nothing.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Money supply (MS) shifts left and every other curve on the Money Market graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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