Question

Assume the reserve ratio is 25 percent and Federal Reserve Banks buy $4 million of U.S. securities from the public, which deposits this amount into checking accounts. As a result of these transactions, the supply of money is: __________
a. not directly affected, but the money-creating potential of the commercial banking system is increased by $12 million.
b. directly reduced by $4 million and the money-creating potential of the commercial banking system is decreased by an additional $12 million.
c. directly increased by $4 million and the money-creating potential of the commercial banking system is increased by an additional $16 million.
d. directly increased by $4 million and the money-creating potential of the commercial banking system is increased by an additional $12 million.

Answer 1

Answer:

d. directly increased by $4 million and the money-creating potential of the commercial banking system is increased by an additional $12 million.

Explanation:

When the Fed buys $4 million in securities put in checking accounts, the money supply grows by $4 million, which means that it directly increased by $4million.

Now, the commercial bank's money-creating capacity grows by:

Total change (money supply) = (1 ÷ Reserve ratio) × Amount deposit

= (1 ÷ 25%) × $4 million

= $16 million

Amount kept as reserves = Reserve ratio × Total change

= 25% × 16 = $4 million

Now by using following formula,

So, money creating potential of commercial banks = Total change - Amount kept as reserves

= $16 million - $4 million

= $12 million (Increased)