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.

Answer 1

B. bank reserves increase by $40 million and the money supply could increase by a maximum of $160 million.

Step-by-step explanation:

In this case there will multiplier effect in the economy. Central bank will pay $40 million by buying bond and it will be deposited in the bank. Bank would its reserves increase by $40 million 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

Therefore, The bank reserve will increase by $40 million and money supply will increase maximum by $ 160 million.