Suppose the reserve ratio is 5 percent, banks do not hold excess reserves, people do not hold currency, and the Bank of Canada purchases $20 million of government bonds. Which statement best describes the effects of Bank of Canada's purchase?

Question

Quizplus · Accepted Answer

With a reserve ratio of 5 percent, the initial excess reserves in the banking system are zero. When the Bank of Canada purchases $20 million of government bonds, it pays for them with newly-created central bank reserves. The banks that sold the bonds now have $20 million in new reserves, and because they can lend out the majority of these reserves, the money supply eventually increases by a multiple of the initial $20 million. Using the money multiplier formula, the potential increase in the money supply is calculated as follows: 1/0.05 x $20 million = $400 million. Therefore, Bank reserves increase by $20 million, and the money supply eventually increases by $400 million.

Suppose the Reserve Ratio Is 5 Percent, Banks Do Not