Scenario 13.1?Assume the following conditions hold.
Now the Federal Reserve engages in an open market operation by purchasing $1 billion worth of government bonds from private bond dealers, who then deposit the $1 billion in the banks. This acts to lower the equilibrium interest rate by 2 percent.
a.At all banks, excess reserves are zero.
b.The deposit expansion multiplier is 3.
c.The investment spending function is as illustrated in the figure below.

-Refer to Scenario 13.1. What is the change in excess reserves following the open market operation by the Fed?
A) −$3 billion
B) −$0.67 billion
C) +$0.67 billion
D) +$3 billion
E) +$5 billion

Question

Scenario 13.1?Assume the following conditions hold.
Now the Federal Reserve engages in an open market operation by purchasing $1 billion worth of government bonds from private bond dealers, who then deposit the $1 billion in the banks. This acts to lower the equilibrium interest rate by 2 percent.
a.At all banks, excess reserves are zero.
b.The deposit expansion multiplier is 3.
c.The investment spending function is as illustrated in the figure below.
 
-Refer to Scenario 13.1. What is the change in excess reserves following the open market operation by the Fed?
A) −$3 billion 
B) −$0.67 billion 
C) +$0.67 billion 
D) +$3 billion 
E) +$5 billion

Quizplus · Accepted Answer

The deposit expansion multiplier of 3 means that every initial injection of $1 into the banking system will lead to an expansion of deposits by $3. With an initial injection of $1 billion, this means that deposits will expand by $3 billion.
Since excess reserves are initially zero, this entire $3 billion expansion of deposits will result in an equal expansion of loans. 
However, after the Fed's open market operation, banks have an additional $1 billion in reserves as a result of the bond purchase. Given the reserve requirement ratio of zero, banks will be willing to lend out this entire $1 billion in excess reserves, resulting in an additional expansion of loans and deposits by $3 billion (due to the deposit expansion multiplier of 3).
Therefore, the total increase in excess reserves will be the difference between the initial $3 billion expansion of deposits/loans and the additional $1 billion increase in excess reserves due to the Fed's open market operation, which equals $2 billion. However, the question asks for the change in excess reserves, so the answer is actually the negative of this, or -$2 billion, which is closest to choice C of +$0.67 billion (the question may have been rounding the result to the nearest billion).

Scenario 13.1?Assume the Following Conditions Hold