Assume that there is a 25 percent reserve ratio and that the Federal Reserve buys $4 billion worth of government securities. If the securities are purchased from the public, this action has the potential to increase bank lending by a maximum of:
A) $4 billion, but only by $1 billion if the securities are purchased directly from commercial banks.
B) $4 billion, but by $16 billion if the securities are purchased directly from commercial banks.
C) $12 billion, or by $16 billion if the securities are purchased directly from commercial banks.
D) $20 billion, or by $20 billion if the securities are purchased directly from commercial banks.

Question

Quizplus · Accepted Answer

The purchase of $4 billion worth of government securities by the Federal Reserve increases the monetary base by $4 billion. With a 25 percent reserve ratio, this has the potential to increase bank lending by a maximum of $16 billion ($4 billion / 0.25). If the securities are purchased directly from commercial banks, the increase in bank lending is limited to the amount of the purchase, which is $4 billion.

Assume That There Is a 25 Percent Reserve Ratio and That