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 of bonds,then by how much does the money supply change?

Question

Quizplus · Accepted Answer

Before the change, the banking system has $100 billion in reserves, which supports a deposit base of $1,000 billion ($100 billion / 0.1 reserve requirement). So the money supply is $1,000 billion.

After the change, the reserve requirement is 8%, so the banking system must hold $80 billion in reserves ($1,000 billion deposit base x 0.08 reserve requirement). With the $10 billion bond purchase, the total reserves increase to $110 billion.

The excess reserves are the difference between total reserves and required reserves, which are now $30 billion ($110 billion - $80 billion). With excess reserves, banks can create new loans and deposits, which increases the money supply. The maximum amount of increase is determined by the money multiplier:

Money multiplier = 1 / reserve requirement = 1 / 0.08 = 12.5

New deposits created = excess reserves x money multiplier = $30 billion x 12.5 = $375 billion

So the money supply increases by $375 billion.

The Banking System Currently Has $100 Billion of Reserves,none of Which