Suppose the reserve ratio is 25% and banks do not hold excess reserves.When the Fed sells $40 million of bonds to the public who then deposit the proceeds into the banking system,

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When the Fed sells bonds to the public, the public pays for the bonds with their deposits, which increases bank reserves by the same amount as the bond sale ($40 million in this case). However, since the reserve ratio is 25%, the maximum potential increase in the money supply is only $160 million (4 times the increase in bank reserves). Therefore, if there are no excess reserves, banks would have to decrease their lending in order to maintain the reserve requirement, leading to a decrease in the money supply by a maximum of $160 million.

Suppose the Reserve Ratio Is 25% and Banks Do Not