The following are simplified consolidated balance sheets for the chartered banking system and the Bank of Canada.Do not cumulate your answers; that is, do return to the data given in the original balance sheets in answering each question.Assume a desired reserve ratio of 5 percent for the chartered banks.All figures are in billions of dollars.CONSOLIDATED BALANCE SHEET: CHARTERED BANKING SYSTEM BALANCE SHEET: BANK OF CANADA
Refer to the above information.Suppose the Bank of Canada buys $2 in securities from the public.As a result of this transaction, the supply of money will:
A)directly increase by $2 and the money-creating potential of the chartered banking system will increase by $38.
B)directly increase by $40 and the money-creating potential of the chartered banking system will increase by $800.
C)directly increase by $2 and the money-creating potential of the chartered banking system will be unaffected.
D)be unaffected but the money-creating potential of the chartered banking system will increase by $40.

Question

The following are simplified consolidated balance sheets for the chartered banking system and the Bank of Canada.Do not cumulate your answers; that is, do return to the data given in the original balance sheets in answering each question.Assume a desired reserve ratio of 5 percent for the chartered banks.All figures are in billions of dollars.CONSOLIDATED BALANCE SHEET: CHARTERED BANKING SYSTEM  BALANCE SHEET: BANK OF CANADA
 Refer to the above information.Suppose the Bank of Canada buys $2 in securities from the public.As a result of this transaction, the supply of money will:
A)directly increase by $2 and the money-creating potential of the chartered banking system will increase by $38. 
B)directly increase by $40 and the money-creating potential of the chartered banking system will increase by $800. 
C)directly increase by $2 and the money-creating potential of the chartered banking system will be unaffected. 
D)be unaffected but the money-creating potential of the chartered banking system will increase by $40.

Quizplus · Accepted Answer

When the Bank of Canada buys securities from the public, it pays for these securities by creating new money. Therefore, the money supply increases by $2. However, this $2 can then be deposited in a chartered bank, which then has the ability to lend out 95% of this deposit (due to the desired reserve ratio of 5%). Therefore, the money-creating potential of the chartered banking system increases by 20 times this amount, or $38. Therefore, the total increase in the money supply is $2 + $38 = $40, and the correct choice is A.

The Following Are Simplified Consolidated Balance Sheets for the Chartered