Assume that the required reserve ratio is 20 percent. If the Federal Reserve buys $80 million in government securities from the general public, then the money supply will immediately
A) increase by $0 with this transaction, and the maximum money-lending potential of the commercial banking system will increase by $400 million.
B) increase by $0 with this transaction, but the maximum money-lending potential of the commercial banking system will increase by $320 million.
C) increase by $80 million with this transaction, and the maximum money-lending potential of the commercial banking system will increase by another $400 million.
D) increase by $80 million with this transaction, and the maximum money-lending potential of the commercial banking system will increase by another $320 million.

Question

Quizplus · Accepted Answer

When the Federal Reserve buys $80 million in government securities, the money supply immediately increases by $80 million. With a reserve ratio of 20%, the money multiplier is 5 (1/0.20), so the maximum money-lending potential increases by $80 million * 4 = $320 million.

Assume That the Required Reserve Ratio Is 20 Percent