Assume that the required reserve ratio is 25%. If the Fed buys $5 million worth of government bonds from the public, the maximum change in the money supply is:

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When the Fed buys $5 million worth of government bonds from the public, the seller of the bond receives $5 million, which the seller can deposit into their bank account. Initially, the bank must hold reserves equal to 25% of the deposit, which is $1.25 million. The remaining $3.75 million can be lent out, which increases the money supply by that amount. However, when the borrower of the loan spends the $3.75 million, that money will eventually end up back in a bank account, which will then be used to make additional loans and further increase the money supply. This process, known as the money multiplier effect, will continue until the full $5 million has been added to the money supply. Therefore, the maximum change in the money supply is more than $5 million.

Assume That the Required Reserve Ratio Is 25