The Fed buys a bond from Sumit and deposits $1,500 cash into his checking account. The reserve requirement is 25%. What is the maximum amount the money supply can increase?

Question

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When the Fed buys a bond and deposits money into Sumit's account, this increases the bank's reserves. With a 25% reserve requirement, the bank can lend out 75% of any deposit. However, the money multiplier effect means that the initial deposit can lead to a maximum increase in the money supply of 1/reserve requirement ratio. Therefore, the maximum increase in the money supply is $1,500 * (1/0.25) = $6,000.

The Fed Buys a Bond from Sumit and Deposits $1,500