Question

The Fed purchases $200 worth of government bonds from the public. The reserve requirement is 12.5 percent, people hold no currency, and the banking system keeps no excess reserves. The U.S. money supply eventually increases by

a.
$25.

b.
between $200 and $300.

c.
$1,600.

d.
$2,500.

Answer 1

c. $1,600.

Step-by-step explanation:

The purchase of $200 worth of government bonds from the public by the Fed is an expansionary monetary policy by Fed using Open Market Operations (OMO). This implies that $200 has been supplied by Fed to the economy.

Since the reserve requirement, r, is 12.5% (or 0.125), the money supply multiplier can be calculated as follows:

Money supply multiplier = 1/r = 1/0.125 = 8

Therefore, we have;

Increase in money supply = $200 × 8 = $1,600

Therefore, the U.S. money supply eventually increases by $1,600.