Assume that the central bank of a country purchases $5,000 worth of government treasury bonds from a firm, which promptly deposits the money in a national Bank. Assuming that the required reserve ratio is 25 percent and banks keep zero excess reserves, the money supply will ultimately:

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When the central bank purchases government treasury bonds, it increases the reserves of the bank that deposited the money. However, this bank is required to keep 25 percent of its deposits as required reserves. Therefore, it can only lend out 75 percent of the $5,000, which is $3,750. Once the borrowers receive the loan, they deposit the money in another bank, which is also required to keep 25 percent as required reserves. The bank can then lend out 75 percent of the $3,750, which is $2,812.50. This process continues with each deposit and each loan, and the maximum increase in the money supply is equal to the initial deposit multiplied by the reciprocal of the required reserve ratio (1/0.25 = 4). Therefore, the maximum increase in the money supply is $5,000 x 4 = $20,000.

Assume That the Central Bank of a Country Purchases $5,000