Initially,all banks have zero excess reserves and the desired reserve ratio is 10%.The Bank of Canada buys $1 million in government securities from a bond dealer who deposits the cheque in Bank A.The bank makes as large a loan as it can to a construction company,which buys materials from a lumber company who deposits the cheque in Bank B.Bank B makes as large a loan as possible to a car dealership.By how much has the money supply grown to this point?

Question

Quizplus · Accepted Answer

When the Bank of Canada buys $1 million in government securities, it directly increases the reserves of Bank A by $1 million. With a 10% reserve ratio, Bank A can lend out 90% of this, or $900,000. This $900,000 is then deposited into Bank B, which can also lend out 90% of it, or $810,000. The total increase in the money supply is the sum of the initial $1 million, plus the $900,000, plus the $810,000, which equals $2.71 million.

Initially,all Banks Have Zero Excess Reserves and the Desired Reserve