Assume that the required reserve ratio for the commercial banks is 25 percent. If the Federal Reserve Banks buy $3 billion in government securities from the nonbank securities dealers, then, as a result of this transaction, the lending ability of the commercial
Banking system will increase by

Question

Quizplus · Accepted Answer

If the Fed buys $3 billion in government securities from nonbank securities dealers, those dealers would deposit the $3 billion into their respective banks. The banks are required to hold 25% of deposits as reserves, so they will hold onto $750 million and lend out the remaining $2.25 billion. This $2.25 billion will then be deposited into other banks, who will also hold onto 25% and lend out the remaining amount. This process continues until the potential increase in the lending ability of the commercial banking system is $9 billion, calculated as follows:

Initial deposit: $3 billion
Reserve requirement (25%): $750 million
Excess reserves: $2.25 billion
Initial deposit × 1/required reserve ratio = potential increase in lending ability
$3 billion × 1/0.25 = $12 billion
Increase - initial deposit = potential increase in lending ability
$12 billion - $3 billion = $9 billion

Assume That the Required Reserve Ratio for the Commercial Banks