In a simplified banking system subject to a 25 percent required reserve ratio, a $1,000 open-market purchase by the Fed would cause the money supply to:
A) increase by $1,000.
B) decrease by $1,000.
C) decrease by $4,000.
D) increase by $4,000.

Question

Quizplus · Accepted Answer

In a simplified banking system subject to a 25 percent required reserve ratio, a $1,000 open-market purchase by the Fed means that the Fed is injecting $1,000 into the banking system. With a required reserve ratio of 25 percent, banks are required to hold onto 25 percent of deposits as reserves and can lend out the remaining 75 percent. Therefore, the injection of $1,000 by the Fed can result in a maximum increase in the money supply of $4,000, which is the result of the initial $1,000 injection being lent out and re-deposited, with 25 percent of each subsequent deposit being held as reserves and the remaining 75 percent being re-lent and re-deposited, and so on. Thus, the money supply increases by $4,000.

In a Simplified Banking System Subject to a 25 Percent