Assume the reserve requirement is 25% and the Federal Open Market Committee buys $4 million of U.S. government bonds from the public. As a result of this transaction, the supply of money is
A) not directly affected but has the potential to be increased by a total of $12 million.
B) directly increased by $4 million and has the potential to be increased by another $12 million.
C) directly reduced by $4 million and has the potential to be reduced by another $12 million.
D) directly increased by $4 million and has the potential to be increased by another $8 million.

Question

Quizplus · Accepted Answer

When the Federal Open Market Committee buys $4 million of U.S. government bonds, they pay for the bonds by adding $4 million into the seller's bank account. Since the reserve requirement is 25%, the bank must keep $1 million (25% of $4 million) as required reserves and can loan out the remaining $3 million. This $3 million can be deposited into another bank, which must keep $750,000 as required reserves (25% of $3 million) and can loan out the remaining $2.25 million. This process can continue, potentially increasing the money supply by a total of $16 million ($4 million divided by 0.25), but since the initial purchase only adds $4 million directly, choice B is the correct answer.

Assume the Reserve Requirement Is 25% and the Federal Open