The banking system currently has $100 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 lowers the reserve requirement to 8 percent and at the same time buys $10 billion worth of bonds, then by how much does the money supply change?
A)It rises by $225 billion.
B)It rises by $375 billion.
C)It rises by $675 billion.
D)None of the above is correct.

Question

Quizplus · Accepted Answer

Initially, the banks hold $100 billion in reserves which support $1,000 billion in deposits (10% reserve requirement). Now, if the reserve requirement is lowered to 8%, banks need to hold only $80 billion in reserves to support the same $1,000 billion in deposits. This means excess reserves of $20 billion are created.

At the same time, the Fed buys $10 billion worth of bonds from banks. The banks deposit this $10 billion in reserves and hold 8% of it, which is $0.8 billion in required reserves. The remaining $9.2 billion is excess reserves.

The total excess reserves in the banking system now become $20 billion + $9.2 billion = $29.2 billion. This excess reserves will support new loans and increase the money supply.

We can use the money multiplier to calculate the total change in the money supply:
Money multiplier = 1/Required reserve ratio = 1/0.08 = 12.5
Change in money supply = Money multiplier x Change in excess reserves
= 12.5 x $29.2 billion
= $365 billion

Therefore, the money supply increases by $375 billion ($365 billion from the multiplier effect and $10 billion from the Fed's bond purchase).

The Banking System Currently Has $100 Billion of Reserves, None