Question

Answer the question on the assumption that the legal reserve ratio is 20 percent. Suppose that the Fed sells $500 of government securities to commercial banks (paid for out of commercial bank reserves) and buys $500 of securities from individuals, who deposit the cash in checking accounts. As a result of the given transactions, the supply of money in the economy will:________ a) rise by $500. b) remain unchanged. c) fall by $500 d) fall by $100.

Answer 1

Answer:

Option A is the correct answer, the supply of money in the economy will rise by $500

Explanation:

The fact that commercial banks paid for the government securities bought from Fed using their reserves,ultimately means that sale had no impact on the cash in circulation as reserves are the minimum cash to be held by commercial banks and not to be lent or paid to bank customers.

From the foregoing,the only transaction that would impact the amount of money in circulation is the purchase of government securities by Fed from individuals.By doing so,Fed releases additional $500 into circulation to pay for the securities bought,hence cash in circulation rises by $500