Question

Assume there is a required reserve ratio of 10% and that banks keep no excess reserves. In which of the following scenarios is there a bigger increase in the money supply.

i. Jane takes $1,000 from under her mattress and deposits it into a checking account.
ii. The Fed purchases $1,000 worth of government securities from a commercial bank.

Answer 1

ii. The Fed purchases $1,000 worth of government securities from a commercial bank.

In this case there will be a bigger increase in money supply, the reason for this is that when the fed purchases $1,000 of securities, the commercial bank will not be required to keep any proportion of that money as the reserve ratio only applies to deposits, whereas this money belongs to the commercial bank itself so it will loan all $1,000 as the bank keeps no excess reserves, where as when Jane deposits $1,000 the bank can only loan out $900 as it is required to keep 10% as reserve. The money multiplier is 1/reserve ratio so in this case 1/0.1= 10. So when Fed buys securities the money supply will increase by 10*1,000= $10,000 and when Jane deposits money the money supply will increase by 10*900= $9,000

Step-by-step explanation: