Assume that there is a 25 percent reserve ratio and that the Federal Reserve buys $200 million worth of government securities. If the securities are purchased from the public, then this action has the potential to increase bank lending by a maximum of
A) $600 million, and also by $600 million if the securities are purchased directly from commercial banks.
B) $800 million, and also by $800 million if the securities are purchased directly from commercial banks.
C) $600 million, but by $800 million if the securities are purchased directly from commercial banks.
D) $800 million, but only by $600 million if the securities are purchased directly from commercial banks.

Question

Quizplus · Accepted Answer

The purchase of $200 million worth of government securities by the Federal Reserve will increase the reserves of banks by $200 million, but due to the reserve ratio of 25 percent, the potential increase in lending will be limited. 
If the securities are purchased from the public, the banks will be able to loan out a maximum of $150 million ($200 million - 25% reserve requirement) which has a potential to increase bank lending by up to $600 million (4 times the initial increase).
If the securities are purchased directly from commercial banks, their reserves will increase by $200 million, but they will also lose the securities worth the same amount, which will decrease their potential lending capacity. The maximum potential increase in lending will then be $800 million ($600 million from the initial increase plus $200 million from the decrease in securities holdings).

Assume That There Is a 25 Percent Reserve Ratio and That