If the Fed sells $10 million in bonds to a bank, and the required reserve ratio is 20 percent, then the banking system can:
A) decrease the money supply by up to $10 million.
B) decrease the money supply by up to $40 million.
C) decrease the money supply by up to $50 million.
D) increase the money supply by up to $2 million.

Question

Quizplus · Accepted Answer

When the Fed sells $10 million in bonds, it reduces the reserves of the banking system by $10 million. With a reserve ratio of 20%, the money multiplier is 1/0.2 = 5. Therefore, the potential decrease in the money supply is $10 million * 5 = $50 million.

If the Fed Sells $10 Million in Bonds to a Bank