Assume that the Federal Reserve Banks sell $40 million in government securities to commercial banks and the reserve ratio is 20 percent, then the effect will be to reduce

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Quizplus · Accepted Answer

When the Federal Reserve sells government securities to commercial banks, it effectively reduces the amount of reserves those banks hold by the amount of the sale. With a reserve ratio of 20%, every dollar of reserves supports $5 of deposits (since 1/0.20 = 5). Therefore, a reduction of $40 million in reserves could potentially reduce the money supply by 5 times that amount, or $200 million, because banks have less to lend out, leading to a multiplier effect in the reduction of the money supply.

Assume That the Federal Reserve Banks Sell $40 Million in Government