Assume there is no leakage from the banking system and that all commercial banks
ID: 1227408 • Letter: A
Question
Assume there is no leakage from the banking system and that all commercial banks are loaned up. Suppose the reserve ratio is 25%. When the Fed buys $40m of bonds from the public who then deposit the proceeds into the banking system,
A. bank reserves increase by $40 million and money supply could increase by a maximum of $40 million. B. bank reserves increase by $40 million and the money supply could increase by a maximum of $160 million. C. bank reserves decrease by $40 million and money supply could decrease by a maximum of $40 million. D. bank reserves decrease by $40 million and money supply could decrease by a maximum of $160 million.Explanation / Answer
In this case there will multiplier effect in the economy. Central bank will pay 40m dollars by buying bond and it will be deposited in the bank. Bank would its reserves increase by 40m dollars and of that 25% will locked as reserve requirement but remaining will be circulated in the economy.
Multiplier = Deposit / Reserve Requirement
40 / 0.25 = 160
So, bank reserve will increase by 40m $ and money supply will increase maximum by $ 160 million.