Assume that the required reserve ratio is 20 percent. If the Federal Reserve buys $80 million in government securities from commercial banks, 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 Fed buys $80 million in government securities from commercial banks, the banks' reserves increase by $80 million. Since the required reserve ratio is 20%, this means that the banks can now lend out an additional $400 million (80 million / 0.20 = 400 million).

Assume That the Required Reserve Ratio Is 20 Percent