The reserve ratio is 20 percent. The Fed buys $1 million in government securities from a bond dealer by transmitting the funds to the dealer's deposit account at Bank A. Bank A makes the maximum loan possible to a construction company, which buys materials with the loan. The check is deposited in Bank B, which loans out all it can to a car dealership. To this point, the money supply has increased by

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When the Fed buys government securities, it injects reserves into the banking system. In this case, the Fed buys $1 million worth of securities, which increases the reserves of Bank A by $1 million. Due to the reserve ratio of 20%, Bank A can make a maximum loan of $5 million to the construction company. This loan increases the deposits of the construction company with Bank A, which increases the reserves of Bank A by $4 million (20% of $5 million). Bank A can now make additional loans of $16 million ($20 million - $4 million - $1 million) due to the reserve ratio. The construction company writes a check for $16 million to the material supplier, who deposits it in Bank B. Bank B now has additional reserves of $16 million and can make loans of up to $80 million ($100 million - $16 million - $4 million). Therefore, the total increase in the money supply is $1 million (initial injection) + $5 million (construction loan) + $16 million (intermediary deposit) + $80 million (final loan) = $102 million. However, we need to account for the initial $1 million that was already counted, so the net increase in the money supply is $101 million or $2.44 million after accounting for the initial $1 million.

The Reserve Ratio Is 20 Percent