Question

The Fed conducts a $10 million open-market purchase of government bonds. If the required reserve ratio is 10 percent, what are the largest and smallest possible increases in the money supply that could result? Explain.

Answer 1

Answer:

1) Largest possible increase is $100 million

2) Smallest possible increase is $10 million

Explanation:

1) In order to find the largest possible increase in the money supply we need to find the money multiplier. The formula for money multiplier is 1/reserve ratio so the money multiplier is 1/0.1= 10. So if the fed conducts an open market purchase of $10 million the maximum amount that the money supply can increase is million * multiplier = 10 million *10 = $100 million, however this will only be the case if the bank decides to keep 0 excess reserves, if the bank decides to keep any excess reserves the money supply increase will be less than a $100 million.

2) The lowest amount that the money supply can increase by is $10 million because if the bank decides to keep all of this money in reserve and loan none of this than the money supply will only increase by $10 million.