Question

Since October 2008, the Federal Reserve has paid interest on excess reserves held by banks. Under these circumstances, if the Fed buys Treasury securities worth $200 million from a bank, how will the money supply be affected

Answer 1

Question Completion:

Assume that the required reserve ratio is 10%, and that all currency is deposited into the banking system.

Answer:

The money supply would decrease by $2 billion or less.

Explanation:

a) Data and Calculations:

Treasury securities bought by the Fed = $200 million

Required reserve ratio = 10%

Money supply = $200 million/0.10 = $2,000 million

b) When the Fed buys Treasury securities worth $200 from the bank, the money supply in the economy will be increased because the action increases the amount of money available to the bank, which the bank can subsequently lend to borrowers.  However, since it is expected to lend only part of the money, the increase in  the money supply will not amount to $2 billion.  The actual money supply will be less than this amount.