Suppose the required reserve ratio is 0.2 and the Fed buys $100,000 in government securities from Big Bank.How much money can the commercial banking system create?

Question

Quizplus · Accepted Answer

The commercial banking system can create a maximum amount of  money that is equal to the amount of excess reserves it holds. When the Fed buys $100,000 in government securities from Big Bank, Big Bank's reserves increase by $100,000. If the required reserve ratio is 0.2, then Big Bank is required to hold $20,000 of reserves against the $100,000 deposit created by the Fed's purchase. This means that Big Bank has $80,000 of excess reserves that it can loan out. Assuming all of the excess reserves are used to make loans, the commercial banking system can create a maximum of $500,000 of new money ($80,000 / 0.2 = $400,000, which is then added to the initial $100,000 deposit created by the Fed's purchase). Therefore, the best choice is B.

Suppose the Required Reserve Ratio Is 0