If the required reserve ratio is 20 percent and the Fed buys a $10,000 security from a depository institution that currently has no excess reserves, the money supply _____

Question

Quizplus · Accepted Answer

When the Fed purchases a security from a depository institution, it pays for the security with newly created reserves. Since the required reserve ratio is 20 percent, the depository institution is required to hold 20 percent of the newly created reserves as required reserves and can lend out the remaining 80 percent as excess reserves.

In this case, the Fed purchases a $10,000 security, which means the depository institution receives $10,000 in newly created reserves. The depository institution is required to hold 20% of this amount as required reserves, which is $2,000. The remaining $8,000 can be lent out as excess reserves.

The process of lending out the excess reserves continues through the banking system, leading to a multiple expansion of the money supply. Given that the required reserve ratio is 20%, the money supply can be calculated as follows:

Money supply = (Newly created reserves / Required reserve ratio) x (1 / Excess reserve ratio)

Money supply = ($10,000 / 0.20) x (1 / 0.80) = $50,000

Therefore, the answer is D. The money supply increases by $50,000.

If the Required Reserve Ratio Is 20 Percent and the Fed