Table 16-7
Metropolis National Bank is currently holding 2% of its deposits as excess reserves.
-Refer to Balance Sheet of Metropolis National Bank. Metropolis National Bank is holding 2% of its deposits as excess reserves. Assume that no banks in the economy want to maintain holdings of excess reserves and that people only hold deposits and no currency. The Fed makes open market purchases of $10,000. The person who sold bonds to the Fed deposits all the funds in Metropolis National Bank. If the bank now loans out all its excess reserves, by how much will the money supply increase?
A)$190,000
B)$200,000
C)$240,000
D)None of the above are correct.

Question

Table 16-7
Metropolis National Bank is currently holding 2% of its deposits as excess reserves. 
-Refer to Balance Sheet of Metropolis National Bank. Metropolis National Bank is holding 2% of its deposits as excess reserves. Assume that no banks in the economy want to maintain holdings of excess reserves and that people only hold deposits and no currency. The Fed makes open market purchases of $10,000. The person who sold bonds to the Fed deposits all the funds in Metropolis National Bank. If the bank now loans out all its excess reserves, by how much will the money supply increase?
A)$190,000 
B)$200,000 
C)$240,000 
D)None of the above are correct.

Quizplus · Accepted Answer

If the bank loans out all of its excess reserves, it can lend out an additional amount equal to its excess reserves. Since the excess reserves are 2% of deposits, the total deposits are $500,000 ($25,000/0.05). Therefore, the bank can lend out an additional $10,000 (2% of $500,000). This means that the money supply will increase by $10,000 in loans plus the original $10,000 from the Fed's open market purchase, which equals $20,000. However, since there is a 20% reserve requirement, the maximum potential increase in the money supply is $20,000/0.2 = $100,000. Therefore, the correct answer is B) $200,000.

Table 16-7 Metropolis National Bank Is Currently Holding 2% of Its Deposits