Suppose that the Federal Reserve buys $400 billion worth of government securities from the public. If the required reserve ratio is 20 percent, the maximum.

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Presentation transcript:

Suppose that the Federal Reserve buys $400 billion worth of government securities from the public. If the required reserve ratio is 20 percent, the maximum increase in the money supply is a) $1,600 billion b) $1,800 billion c) $2,000 billion d) $2,200 billion e) $2,400 billion

This technical process by which the money expansion occurs through a purchase of bonds from the public involves the following: The public depositing the money in the banking system. We must assume this. 2) Banks reserving 20%. 3) Banks lending the other 80%. 4) We use the Money Multiplier (aka Deposit Expansion Multiplier) to estimate how much money can be created by lending throughout the banking system. 5) Then we add the original deposit to total loans to get the maximum increase in the Money Supply.

When the $400 billion is deposited into the banking system (the assumption here), the banking system can create the following amount in new loans: 1) 1/.20 = 5 = Multiplier. 2) .20 x $400 billion = $80 billion or required reserves. 3) The rest $400 billion - $80 billion = $320 billion are excess reserves and may be loaned out. 4) 5 x $320 billion = $1,600 billion in new loans that could be made by the banking system. 5) Add $400 and $1,600 Billion to get $2,000 Billion or C. Because when the Fed buys government securities, the original $400 billion counts as new money and is added to the money created by lending.

If the Fed had bought $400 Billion in bonds from commercial banks, not the public, the answer would still be $2,000 Billion. Since the bonds would be the Banks’ Asset, any cash from the sale would also be the Bank’s Asset. As the cash is not customer money in a Checkable Deposit, it is not subject to the reserve ratio. Therefore the banks could loan out the entire $400 Billion. With the multiplier being 5, then 5 x $400 Billion also equals $2,000 Billion.

If the $400 billion came from outside the Fed (say from Grandma’s mattress), it would not count as new money and the answer would be A or $1,600 Billion (5 x $320 Billion in excess reserves. However: Because the original deposit counts as new money since it came from the Fed in this question, the easy way to answer this is to use the multiplier times the original deposit or 5 x $400 billion = $2,000 billion or answer C.