Suppose the Fed purchases $100 million of U.S. securities from security dealers. If the reserve requirement is 20 percent, the currency holdings of the public are unchanged, and banks have zero excess reserves both before and after the transaction, the total impact on the money supply will be a:
A) $100 million decrease in the money supply.
B) $100 million increase in the money supply.
C) $200 million increase in the money supply.
D) $500 million increase in the money supply.

Question

Quizplus · Accepted Answer

When the Fed purchases $100 million of U.S. securities, it injects $100 million into the banking system. With a 20% reserve requirement, banks can lend out 80% of new deposits. This process of lending and redepositing can theoretically increase the money supply by up to 5 times the original amount ($100 million x 5 = $500 million), assuming banks lend out the maximum possible and all other conditions remain constant. This is known as the money multiplier effect.

Suppose the Fed Purchases $100 Million of U