The banking system currently has $10 billion of reserves, none of which are excess. People hold only deposits and no currency, and the reserve requirement is 10 percent. If the Fed raises the reserve requirement to 20 percent and at the same time buys $1 billion worth of bonds, then by how much does the money supply change?
A)It falls by $45 billion.
B)It falls by $52 billion.
C)It falls by $55 billion.
D)None of the above is correct.

Question

Quizplus · Accepted Answer

Initially, with a 10% reserve requirement, the money multiplier is 10. With $10 billion in reserves, the money supply is $100 billion. Raising the reserve requirement to 20% changes the money multiplier to 5, reducing the money supply to $50 billion. The Fed's $1 billion bond purchase adds $5 billion to the money supply (with the new multiplier), resulting in a net decrease of $45 billion.

The Banking System Currently Has $10 Billion of Reserves, None