For a variety of reasons, a bank sometimes will hold more reserves than is legally required. These reserves are known as excess reserves. How does holding excess reserves affect the money supply? Choose one: A. The money supply will increase as banks hold more vault cash. B. The money supply will increase as banks loan out more money. C. There is no impact. The level of deposits and loans will be unaffected. D. The money supply will decrease as banks loan out less money. E. The money supply will increase as a bank’s vault cash falls.

Money Supply is created by commercial banks through the 'process of credit creation'. Commercial banks create final deposits many times initial deposits by 'money multiplier'.

The process : A person deposits (eg 100) in bank. Banks retain reserves (eg 20% = 20), & lend out remaining (eg 80). Then the lent (80) are spent by borrower. One person spending is other person income, so they come back in the bank account of income receiver. Again, reserves (20% of 80 = 16) are retained & rest (64) is lent. This deposit multiplying effect keeps on occurring until : Final Deposits = ( 1 / Reserve Ratio ) x Initial Deposits. [ Eg : Final Deposits = 1/0.20 x Initial Deposits = 5 x 100 = 500]

So, Reserve Ratio is inversely related to money supply (credit) creation by commercial banks. Higher the reserve ratio, lesser is the money supply (credit) creation & lower the reserve ratio, higher is the money supply (credit) creation. Hence, increase in excess reserves retained by commercial banks reduces the bank's capability to lend money & create less money supply (credit).