Assume that there is a 25 percent reserve ratio and that the Federal Reserve buys $4 billion worth of government securities. If the securities are purchased from the general public, this action has the potential to increase money supply by a maximum of
A) $16 billion, but only by $14 billion if the securities are purchased directly from commercial banks.
B) $14 billion, but by $16 billion if the securities are purchased directly from commercial banks.
C) $16 billion, and also by $16 billion if the securities are purchased directly from commercial banks.
D) $14 billion, and by $20 billion if the securities are purchased directly from commercial banks.

Question

Quizplus · Accepted Answer

The potential maximum increase in the money supply is determined by the money multiplier, which is the reciprocal of the reserve ratio. With a 25 percent reserve ratio, the money multiplier is 1/0.25 = 4. Therefore, a $4 billion purchase of government securities has the potential to increase the money supply by 4 * $4 billion = $16 billion, regardless of whether the securities are purchased from the general public or directly from commercial banks.

Assume That There Is a 25 Percent Reserve Ratio and That