Question

Assume that the required reserve ratio is 25 percent. If the Federal Reserve sells $120 million in government securities to the general public, the money supply will immediately:
A. Decrease by $120 million with this transaction, and the decrease in money supply could eventually reach a maximum of $480 million
B. Decrease by $120 million with this transaction, and the decrease in money supply could eventually reach a maximum of $360 million
C. Increase by $120 million with this transaction, and the increase in money supply could eventually reach a maximum of $480 million
D. Increase by $120 million with this transaction, and the increase in money supply could eventually reach a maximum of $360 million

Answer 1

Answer: Option (B) is correct.

Explanation:

Given that,

Reserve ratio = 25%

Fed reserve bank sells (securities) to public = $120 million

When a central bank sells the government securities to the public then as a result money supply in an economy decreases. This is an instrument of monetary policy known as " Open market Operations".

The supply of money is directly decreases by $120 million.

and

Money creating potential of banks = Amount of securities × $(\frac{1}{rr} - 1)$

                                                          = 120 × $(\frac{1}{0.25} - 1)$

                                                          = 120 × 3

                                                          = $360 million

Hence, a decrease in money supply could eventually reach a maximum of $360 million.