Question

Assuming that the Federal Reserve Banks sell $40 million in government securities to commercial banks and the reserve ratio is 20 percent, then the effect will be to reduce:

Excess reserves by $8 million

Excess reserves by $200 million

The money supply by potentially $200 million

The money supply by potentially $400 million

Answer 1

The Federal Reserve selling $40 million in government securities to commercial banks would decrease excess reserves by $8 million and potentially reduce the money supply by up to $200 million, considering a 20% reserve requirement.

Step-by-step explanation:

When the Federal Reserve Banks sell $40 million in government securities to commercial banks with a reserve ratio of 20 percent, the effect will be to reduce the excess reserves by $8 million. Since the banks have to hold 20% in reserve, they would need to keep $8 million ($40 million * 20%) from the securities sale in reserves.

This transaction reduces the potential for money creation through the banking system's ability to lend money and thus leads to a decrease in the money supply by potentially $200 million. This is calculated by using the money multiplier formula (1/reserve ratio), which in this case is 1/0.20 = 5, and then multiplying the decrease in excess reserves by this multiplier: $8 million * 5 = $40 million.

Remember that when a bank purchases bonds, it must either have excess reserves or it reduces its loans to maintain required reserves. The reduction in loans directly translates to a decrease in the money supply because it lowers the amount of money banks can create through the lending process.