Assume a money multiplier of 3. If the Treasury finances a $30 million expenditure by selling securities to the Fed, the effect of this transaction on the money supply is that it will
A) remain unchanged.
B) rise by $3 million.
C) rise by $30 million.
D) rise by $90 million.

Question

Quizplus · Accepted Answer

The money multiplier is defined as the reciprocal of the reserve ratio, which can be expressed as MM = 1/rr. If the money multiplier is 3, it implies that the reserve ratio is 1/3 or 33.33%. When the Treasury sells securities to the Fed, the Fed pays for them by creating new money. Since the money multiplier is 3, every $1 of reserves can support $3 of deposits. Therefore, the purchase of $30 million of securities by the Fed can potentially create new deposits of up to $90 million ($30 million x 3). However, this assumes that banks are willing to lend out all their excess reserves which is not always the case. Therefore, the actual increase in the money supply might be less than $90 million. In this case, the expenditure by the Treasury is not financed by tax revenue, and it results in an injection of new money into the economy, which leads to an increase in the money supply by $30 million.

Assume a Money Multiplier of 3