Suppose the Fed sells $100 million of U.S. securities to the public. 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

The sale of $100 million of U.S. securities by the Fed reduces the reserves of the banking system by $100 million (as the public pays for the securities by writing checks on their deposits, which reduces the reserves of the banks), resulting in a potential decrease in the money supply by a maximum of $500 million (1/0.2 reserve requirement). Since banks have zero excess reserves before and after the transaction, they must reduce their loans by $100 million after the sale to meet the new required reserve ratio of 20%. Therefore, the money supply decreases by $100 million in reserves and $400 million due to the reduction in loans, resulting in a total decrease of $500 million.

Suppose the Fed Sells $100 Million of U