Assume the required reserve ratio is 25 percent. If the Federal Reserve sells $120 million in government securities to the public, the money supply will immediately:
A) decrease by $120 million and the maximum money-lending potential of the commercial banking system will decrease by $120 million.
B) decrease by $120 million and the maximum money-lending potential of the commercial banking system will decrease by $480 million.
C) increase by $120 million and the maximum money-lending potential of the commercial banking system will increase by $480 million.
D) increase because the securities are an asset to the commercial banks and a liability to the Federal Reserve.

Question

Quizplus · Accepted Answer

When the Federal Reserve sells $120 million in securities, the money supply decreases by that amount. The maximum money-lending potential decreases by $480 million because the money multiplier is 1/0.25 = 4, and $120 million x 4 = $480 million.

Assume the Required Reserve Ratio Is 25 Percent