In a fractional reserve banking system with no excess reserves and no currency holdings, suppose the central bank buys $100 million of bonds. Which statement best describes the effects of this open-market operation?
A) Reserves and the money supply increase by less than $100 million.
B) Reserves increase by $100 million, and the money supply increases by $100 million.
C) Reserves increase by $100 million, and the money supply increases by more than $100 million.
D) Both reserves and the money supply increase by more than $100 million.

Question

Quizplus · Accepted Answer

When the central bank buys $100 million of bonds in a fractional reserve banking system, it directly increases reserves by $100 million. Banks can then lend out a portion of these reserves, which gets deposited and re-lent multiple times, leading to a multiplier effect on the money supply. Therefore, the money supply increases by more than $100 million.

In a Fractional Reserve Banking System with No Excess Reserves