Assume that there is no leakage from the banking system and that all banks are lending their maximum amount. The liquidity ratio is 20%. If the Bank of England sells £10 million worth of government securities to the public, the change in the money supply will be

Question

Quizplus · Accepted Answer

The sale of £10 million in government securities by the Bank of England to the public effectively removes that amount from the money supply. With a liquidity ratio of 20%, banks are required to hold 1/5 of deposits as reserves, meaning they can lend out 4/5 of deposits. This creates a money multiplier effect of 1/(0.20) = 5. Therefore, removing £10 million from the banking system would reduce the potential money supply by 5 times that amount, or £50 million, leading to a decrease in the money supply by £50 million.

Assume That There Is No Leakage from the Banking System