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Exhibit: Fed Buys Bonds
Scenario 1: Fed Buys Bonds from Sheila Jones
Consider a banking system in which the reserve requirement is 10%, banks try not to hold excess reserves, consumers and firms hold money only in the form of checking account balances, and all loan proceeds are spent. Suppose initially all banks in the system are loaned up. Now, suppose that the Fed buys a $100,000 bond from Sheila Jones, who banks at the Perez Bank, and that she deposits her check in her checking account at Perez Bank.
-(Exhibit: Fed Buys Bonds) Once the full impact of the Fed's open market purchase and Sheila's deposit worked its way through the banking system, what is the maximum change on the money supply as a result of these two events?
A) Money supply falls by $100,000.
B) Money supply falls by $1,000,000.
C) Money supply rises by $10,000.
D) Money supply rises by $1,000,000.

Question

Quizplus · Accepted Answer

When the Fed buys a bond from Sheila Jones, it injects $100,000 into the economy. Sheila deposits this money into her checking account at Perez Bank, which increases the bank's reserves by $100,000. Since the reserve requirement is 10%, Perez Bank can now lend out $90,000 of the new reserves, which can be spent by borrowers and eventually end up deposited into other banks. As this money multiplies through the banking system, the overall money supply expands. The money supply can expand by up to 10 times the initial injection of reserves, which in this case is $1,000,000 (since $100,000 x 10 = $1,000,000). Therefore, the correct answer is D) Money supply rises by $1,000,000.

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