Suppose the reserve ratio is 4 percent,banks do not hold excess reserves,people do not hold currency,and the Bank of Canada purchases $25 million of government bonds.Which statement best describes the effects of Bank of Canada's purchase?
A) Bank reserves increase by $25 million,and the money supply eventually increases by $500 million.
B) Bank reserves decrease by $25 million,and the money supply eventually increases by $500 million.
C) Bank reserves increase by $25 million,and the money supply eventually decreases by $500 million.
D) Bank reserves decrease by $25 million,and the money supply eventually decreases by $500 million.

Question

Quizplus · Accepted Answer

The reserve ratio is 4 percent, which means that banks hold 4 percent of deposits as reserves and lend out the rest. With no excess reserves, the Bank of Canada's purchase of $25 million of government bonds increases the banks' reserves by $25 million. Given the reserve ratio, banks can lend out $25 million/0.96 = $26.04 million. When this money is borrowed and deposited in other banks, those banks are required to hold 4 percent as reserves and lend out the rest. The process repeats until the total increase in the money supply is $500 million ($26.04 million multiplied by the money multiplier of 0.96). Thus, choice A is correct.

Suppose the Reserve Ratio Is 4 Percent,banks Do Not Hold