Suppose the reserve ratio is 25% and banks do not hold excess reserves. When the Fed sells $40 million of bonds to the public,
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 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.

Question

Quizplus · Accepted Answer

When the Fed sells $40 million of bonds to the public, bank reserves decrease by $40 million. Since the reserve ratio is 25%, this decrease in reserves can result in a maximum decrease in the money supply of 4 times the initial amount of reserves, which is $160 million. Therefore, the money supply could decrease by a maximum of $160 million.

Suppose the Reserve Ratio Is 25% and Banks Do Not