Assume that the required reserve ratio is 25 percent. If the Federal Reserve sells $120 million in government securities to the general public, the money supply will immediately
A) decrease by $120 million with this transaction, and the decrease in money supply could eventually reach a maximum of $480 million.
B) decrease by $120 million with this transaction, and the decrease in money supply could eventually reach a maximum of $360 million.
C) increase by $120 million with this transaction, and the increase in money supply could eventually reach a maximum of $480 million.
D) increase by $120 million with this transaction, and the increase in money supply could eventually reach a maximum of $360 million.

Question

Quizplus · Accepted Answer

When the Federal Reserve sells $120 million in government securities to the general public, the reserves of commercial banks will decrease by $120 million as a result. This means that there will be a decrease in the amount of money that banks can lend out, which in turn leads to a decrease in the money supply. The initial decrease in the money supply will be $120 million, but it could eventually reach a maximum of $480 million based on the required reserve ratio of 25 percent. This is because each time a bank receives deposits, it must hold 25 percent of those deposits as reserves and can lend out the remaining 75 percent. Assuming all banks follow this requirement, and the money continues to be deposited and loaned out, the decrease in the money supply could eventually be up to $480 million (4 times the initial amount sold by the Federal Reserve).

Assume That the Required Reserve Ratio Is 25 Percent