Question

If the reserve ratio is 10%, and banks do not hold excess reserves, when the Fed purchases $10 million of government bonds, bank reservesA) increase by $10 million and the money supply could eventually increase by $10 million.B) decrease by $10 million and the money supply could eventually decrease by $100 million.C) increase by $10 million and the money supply could eventually increase by $100 million.D) decrease by $10 million and the money supply could eventually decrease by $10 million

Answer 1

Answer:

Option (C) is correct.

Explanation:

Given that,

Reserve ratio = 10%

Fed purchases government bonds = $10 million

The money multiplier:

= 1 ÷ reserve ratio

= 1 ÷ 0.10

= 10.

Increase in Money supply:

= Multiplier × Government purchases

= 10 × 10

= 100.

Therefore, the bank reserves increase by $10 million and the money supply could eventually increase by $100 million.