Question

Assume that the reserve requirement for demand deposits is 20 percent, that the banks hold no excess reserves, and that the public holds no currency. If the central bank sells $10,000 worth of government securities to commercial banks, the total money supply will

A) increase by $10,000
B) increase by $50,000
C) decrease by $10,000
D) decrease by $50,000
E) not change

Answer 1

C

Step-by-step explanation:

When the central bank sells government securities to commercial banks, the banks pay for these securities by giving up reserves held at the central bank. Since the reserve requirement for demand deposits is 20 percent, the banks must hold reserves equal to $2,000 for every $10,000 of deposits.

When the central bank sells $10,000 worth of government securities, the banks' reserves decrease by $10,000 x 20% = $2,000. As a result, the banks are able to support $10,000 / (1 - 20%) = $12,500 in deposits (which is less than the initial deposits of $10,000 / (1 - 20%) = $12,500 before the sale of government securities).

Therefore, the total money supply decreases by $12,500 - $10,000 = $2,500.