Question

Suppose the required reserve ratio is 10 percent, and the Fed buys $5 million worth of bonds from the public. If the public deposits this amount into transactions accounts, the money supply will

Answer 1

Answer and Explanation:

The computation is shown below

As we know that

The increase in money supply is

Increase in money supply = (1 ÷ Required reserve ratio) × Excess reserve.

Since the required reserve ratio is 10%

And, the deposit is $5 million

So, the required reserve is

= $5 million × 0.10

= $500,000

Also

Total reserve = required reserve + excess reserve

where,

Total Reserve = $5,000,000

And required reserve = $500,000.

So, Excess reserve is

= $5,000,000 - $500,000

= $4,500,000

Now, Increase in money supply is

= (1 ÷ 0.10) × $4,500,000

= $4.5 million

So it would rise directly by $4.5 million and have an extra lending capacity of $4.5 million that would be created for the banking system