Scenario 2: Fed sells bonds to Henry Hyde
Consider a banking system in which the reserve requirement is 10%, banks try not to hold excess reserves, consumers and firms hold money only in the form of checking account balances, and all loan proceeds are spent. Suppose initially all banks in the system are loaned up. Now, suppose that the Fed sells a $50,000 bond to Henry Hyde, who pays for the bond by writing a check drawn against Jekyll Bank.
-Refer to Scenario 2. Once the full impact of the Fed's open market sale works its way through the banking system, what is the maximum change on the money supply as a result of these two events?
A) Money supply rises by $5,000.
B) Money supply rises by $500,000.
C) Money supply falls by $50,000.
D) Money supply falls by $500,000.

Question

Quizplus · Accepted Answer

When the Fed sells a bond, it reduces the reserves in the banking system. With a reserve requirement of 10%, the money multiplier is 10. Therefore, a $50,000 reduction in reserves can lead to a maximum contraction of $500,000 in the money supply.

Scenario 2: Fed Sells Bonds to Henry Hyde