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Money Multiplier: Worst-Case Scenario for the Greek Drachma

Imagine one of the worst case scenarios realizes in October 2012, in which Greece does not belong to the eurozone any more, so Greece goes back to the use of its own currency, Greek drachma. Suppose that the monetary base, which is equivalent to the sum of all the initial deposits in the banking system, has risen from 1 trillion drachmas in October 2012 to 3 trillion drachmas in April 2013. Due to the concern on the state of the economy and on possible defaults, however, the reserve ratio of commercial banks rises, too. In other words, commercial banks hold onto more cash reserves than before, instead of extending the loans to households and business. Suppose that the reserve ratio rises from 0.1 in October 2012 to 0.4 in April 2013. Again, the numbers given in this question are hypothetical, not real.

(1) Based on the description given above, compute the money multiplier in October 2012 and in April 2013.

(2) Based on the description given above, compute the sizes of the money supply in October 2012 and in April 2013.

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Solution Preview

Money Multiplier (MM) = 1/Reserve Ratio (RR)

MM2012 = ...

Solution Summary

This solution explains what would happen to Greece's money supply if the worst-case scenario came true and Greece returned to its own currency, the Greek drachma.