Assume that the required reserve rate is ten percent, banks want to hold excess reserves in an amount that equals three percent of deposits, and the public withdraws ten percent of every deposit in cash. An open market purchase of $1 million by the Fed will see banking system deposits increase by:

Question

Quizplus · Accepted Answer

When the Fed makes an open market purchase of $1 million, the banking system reserves will increase by $1 million x 0.1 (required reserve rate) = $100,000. This will allow banks to lend out additional funds of $1 million - $100,000 = $900,000. However, banks also want to hold excess reserves equal to 3% of deposits, so they will hold back 0.03 x ($1 million + $900,000) = $57,000. This means that the total increase in deposits will be $1 million - $57,000 = $943,000. Additionally, because the public withdraws 10% of every deposit in cash, the total increase in deposits will be $943,000 x 0.9 = $848,700. Therefore, the correct answer is A, as the increase in deposits will be more than $1 million (initially lent by the Fed) but less than $10 million (without the cash withdrawal).

Assume That the Required Reserve Rate Is Ten Percent, Banks