The Fed buys a bond from Sumit and deposits $1,500 cash into his checking account. The reserve requirement is 25%. How many dollars' worth of loans can the banking system create?

Question

Quizplus · Accepted Answer

The initial impact of the Fed buying a bond and depositing cash into Sumit's checking account is an increase in the excess reserves of Sumit's bank. The excess reserves are calculated as:
Excess Reserves = Deposits - Required Reserves
Since the Fed deposited $1,500 cash into Sumit's account, this becomes the new deposit, and the required reserves are calculated by multiplying the deposit by the reserve ratio of 25%:
Required Reserves = Deposit * Reserve Ratio
Required Reserves = $1,500 * 0.25 = $375
Therefore, the excess reserves of Sumit's bank are:
Excess Reserves = $1,500 - $375 = $1,125
Since the banking system can create loans equal to its excess reserves, the maximum amount of loans that can be created is $1,125. However, each time a loan is created, a portion of it must be held as required reserves, so only a fraction of the excess reserves can be loaned out. The maximum amount of loans that can be created is determined by the money multiplier, which is the reciprocal of the reserve ratio:
Money Multiplier = 1 / Reserve Ratio
Money Multiplier = 1 / 0.25 = 4
Therefore, the maximum amount of loans that can be created is:
Max Loans = Excess Reserves * Money Multiplier
Max Loans = $1,125 * 4 = $4,500
Thus, the correct choice is (C).

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