Suppose the reserve ratio is 10 percent, banks do not hold excess reserves, people do not hold currency, and the Bank of Canada purchases $20 million of government bonds. Which of the following best describes the effects of Bank of Canada's purchase?
A)Bank reserves increase by $20 million, and the money supply eventually increases by $200 million.
B)Bank reserves decrease by $20 million, and the money supply eventually increases by $200 million.
C)Bank reserves increase by $20 million, and the money supply eventually decreases by $200 million.
D)Bank reserves decrease by $20 million, and the money supply eventually decreases by $200 million.

Question

Quizplus · Accepted Answer

With a reserve ratio of 10 percent, the Bank of Canada's purchase of $20 million in government bonds will increase bank reserves by $20 million (10% of the $20 million purchase). Since banks do not hold excess reserves, they will loan out the additional $20 million, which will be deposited into other banks creating more reserves. As this process repeats, the money supply will eventually increase by a multiple of the initial $20 million, which is 1/RR, where RR is the reserve ratio. Therefore, the money supply will increase by $200 million (1/0.1 x $20 million).

Suppose the Reserve Ratio Is 10 Percent, Banks Do Not