Suppose that the desired reserve ratio is 0.2, and the Bank of Canada buys $5,000 of Canadian government securities from Bank A.Bank A then lends $4,000 and keeps $1,000 in its vault in cash.In this round of the money-creation process, by what amount has the money supply increased, as measured by M1+?

Question

Quizplus · Accepted Answer

The initial increase in the monetary base (the money supply held by the banks) is $5,000, as Bank of Canada purchased $5,000 in government securities. According to the desired reserve ratio of 0.2, Bank A needs to keep 20% of its deposits in reserve, which is $800 ($4,000 x 0.2). Therefore, it can lend out the remaining $3,200 ($4,000 - $800). This $3,200 is added to the money supply. Thus, the total increase in the money supply is $5,000 + $3,200 = $8,200, which is equivalent to the initial increase in the monetary base multiplied by the money multiplier (1 / 0.2) = $5,000 x 5 = $25,000. However, we are only interested in the increase as measured by M1+, which only includes the amount of currency and demand deposits held by the public. Since Bank A kept $1,000 in its vault in cash, the increase in M1+ is only equal to the amount lent out, which is $3,200. Therefore, the correct answer is B, by $4,000.

Suppose That the Desired Reserve Ratio Is 0