Suppose an economy has $200,000 of demand deposits and $40,000 of excess reserves with a 10% required reserve ratio. If the monetary authorities raise the required reserve ratio to 20%, then which of the following will likely follow?
A. Excess reserves will decrease by $20,000.
B. There will be no more excess reserves in the system.
C. The excess reserves will rise by 10%.
D. The excess reserves will fall by 10%.

A. Excess reserves will decrease by $20,000.  

Explanation:

Suppose an economy has $200,000 of demand deposits and $40,000 of excess reserves with a 10% required reserve ratio. If the monetary authorities raise the required reserve ratio to 20%, then which of the following will likely follow?

Excess reserves are capital reserves held by a bank or financial institution in excess of what is required by regulators.

Therefore if the  excess reserves with a 10% required reserve ratio on $200,000 of demand deposits, is $40,000

Therefore a rise in 10% on $200,000 of demand deposits will be additional $20,000 required in normal reserves, which will reduce excess reserves by that amount.

A. Excess reserves will decrease by $20,000

Explanation:

If demand deposits is $200,000, then $20,000 ($200,000 x 0.1) must be held as required reserves.

Mathematically;

RR= DD×r

RR= required reserve (?)

DD= demand deposits ($200,000)

r= reserve rating (0.10)

RR=$200,000×0.10

RR=$20,000

So if reserve ratio is increased to 20%

RR= required reserve (?)

DD= demand deposits ($200,000)

r= reserve rating (0.20)

RR=$200,000×0.20

RR=$40,000

Meanwhile, our excess reserve is $40,000

So if we increase the reserve ratio by 20% our required reserve will increase to $40,000 which will reduce our excess reserve from $40,000 to $20,000.

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