Suppose the Fed sells $100 million of U.S. securities to the 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.
B) $500 million increase.
C) $500 million decrease.
D) $100 million increase.

Question

Quizplus · Accepted Answer

When the Fed sells $100 million of U.S. securities to security dealers, it receives payment in the form of reserves. Since the reserve requirement is 20%, banks will be required to hold $20 million in reserves and can loan out only $80 million. As banks have zero excess reserves both before and after the transaction, they will have to reduce their loans by the amount of the reserves that they need to hold, which is $20 million. So the money supply decreases by $20 million x 25 (the reciprocal of the reserve requirement of 20%) = $500 million. Therefore, the total impact on the money supply will be a $500 million decrease.

Suppose the Fed Sells $100 Million of U