Suppose the required reserve ratio is 0.2 and the Fed buys $100,000 in government securities from Big Bank.The commercial banking system creates _____ as a result of this initial injection by the Fed.

Question

Quizplus · Accepted Answer

The initial injection of $100,000 in government securities increases the reserves of Big Bank by $100,000. The required reserve ratio is 0.2, which means that Big Bank needs to hold 20% of their deposits in reserves. Therefore, Big Bank can now lend out 80% of the $100,000 increase in their reserves, which is $80,000. When this $80,000 is deposited into other banks, those banks can also lend out 80% of that deposit, and this process continues. The total amount of money created by the initial injection is determined by the simple deposit multiplier formula: 
total money created = (1/required reserve ratio) x initial injection
total money created = (1/0.2) x $100,000
total money created = $500,000
Therefore, the commercial banking system creates $500,000 as a result of the Fed's initial injection of $100,000.

Suppose the Required Reserve Ratio Is 0