Assume that there is a 25 percent desired reserve ratio and that Bank of Canada buys $200 million worth of government securities.If the securities are purchased from the public, then this action has the potential to increase bank lending by a maximum of:
A)$600 million, and also by $600 million if the securities are purchased directly from chartered banks.
B)$800 million, and also by $800 million if the securities are purchased directly from chartered banks.
C)$600 million, but by $800 million if the securities are purchased directly from chartered banks.
D)$800 million, but only by $600 million if the securities are purchased directly from chartered banks.

Question

Quizplus · Accepted Answer

If Bank of Canada buys $200 million worth of government securities from the public, the money supply will increase by $200 million. As the desired reserve ratio is 25 percent, the initial increase in bank reserves will lead to an increase in the checkable deposits by $200 million / 0.25 = $800 million. Therefore, bank lending can potentially increase by a maximum of $600 million.

However, if the Bank of Canada purchases $200 million worth of government securities directly from chartered banks, the banks' reserves will increase by $200 million, and the potential increase in checkable deposits will also be $800 million. In this case, bank lending can potentially increase by a maximum of $800 million, which is higher than if the securities were purchased from the public. Therefore, the correct answer is C, as bank lending can potentially increase by $600 million if the securities are purchased from the public, but by $800 million if the securities are purchased directly from chartered banks.

Assume That There Is a 25 Percent Desired Reserve Ratio