The reserve ratio equals 20 percent. The Fed buys $1 million in U.S. government securities. The most the money supply can increase is

Question

Quizplus · Accepted Answer

The reserve ratio is set at 20 percent, meaning that banks must hold at least 20 percent of their deposits as reserves. Therefore, when the Fed buys $1 million in securities, the banks' reserves increase by $1 million * (1 - reserve ratio) = $1 million * (1-0.20) = $800,000. This new reserve can support an increase in the money supply of up to $800,000 / reserve ratio = $800,000 / 0.20 = $4 million. Therefore, the most the money supply can increase is $4 million, making choice C the correct answer.

The Reserve Ratio Equals 20 Percent