If the reserve ratio is 5 percent,banks do not hold excess reserves,and people do not hold currency,then when the Fed purchases $20 million worth of government bonds,bank reserves
A)increase by $20 million and the money supply eventually increases by $400 million.
B)decrease by $20 million and the money supply eventually decreases by $400 million.
C)increase by $20 million and the money supply eventually increases by $100 million.
D)decrease by $20 million and the money supply eventually decreases by $100 million.

Question

Quizplus · Accepted Answer

If the reserve ratio is 5%, then banks are required to hold 5% of their deposits as reserves. If they do not hold excess reserves, then when the Fed purchases $20 million worth of government bonds, the banks receive $20 million in reserves. Since they are not holding excess reserves, this $20 million is available for lending. By using the money multiplier formula (1/reserve ratio), we can see that the initial increase in reserves of $20 million can create a maximum increase in the money supply of $400 million. Therefore, the correct answer is A)increase by $20 million and the money supply eventually increases by $400 million.

If the Reserve Ratio Is 5 Percent,banks Do Not Hold