Suppose the reserve ratio is 20 percent and banks do not hold excess reserves. Suppose the Bank of Canada sells $10 million of bonds to the public. Which statement best describes the effects of this open-market operation?
A) Bank reserves increase by $1 million, and the money supply eventually increases by $10 million.
B) Bank reserves increase by $10 million, and the money supply eventually increases by $50 million.
C) Bank reserves decrease by $1 million, and the money supply eventually increases by $10 million.
D) Bank reserves decrease by $10 million, and the money supply eventually decreases by $50 million.

Question

Quizplus · Accepted Answer

When the Bank of Canada sells bonds to the public, the public pays for these bonds with their deposits, which decreases the reserves in the banking system by the amount of the sale, in this case, $10 million. With a reserve ratio of 20%, each dollar of reserves supports $5 of money (1/0.20 = 5). Therefore, a $10 million decrease in reserves leads to a $50 million decrease in the money supply.

Suppose the Reserve Ratio Is 20 Percent and Banks Do