Impact of banks behavior to hold more excess reserves and make fewer loans on the quantity of money with the help of an equation of the money supply.
Assume that of the ongoing financial turmoil banks become more prudent: that is, other things equal, banks want to hold more excess reserves and make fewer loans.
a. With the help of an equation of the money supply, explain the effect that this change in bank behavior will have on the quantity of money.
b. Next, use a graph of the liquidity preference theory of interest rate determination to explain the effect on the interest rate and the quantity of money.
c. Next, use a graph of the loanable funds theory of interest rate determination to confirm the results in your answer to b.