Final answer:
When the Federal Reserve buys government securities, it increases the reserves of commercial banks, which then have the potential to increase the money supply. With a 25% reserve requirement, a $50 million purchase can lead to a $250 million increase in the potential money supply due to the money multiplier effect.
Step-by-step explanation:
When the Federal Reserve buys $50 million in government securities from commercial banks and the reserve ratio is 25%, it directly increases the actual supply of money by $50 million. This purchase also affects the potential money supply, as banks are able to use the new funds to extend more loans.
Given the reserve ratio of 25%, commercial banks must hold 25 cents in reserve for every dollar deposited. Thus, when the Federal Reserve's purchase increases reserves by $50 million, banks can issue up to $200 million in new loans ($50 million / 0.25 = $200 million), as the money multiplier effect takes place. Consequently, the total potential increase in the money supply would be the $50 million in original reserves plus the potential $200 million from loan creation, aggregating to a potential increase of $250 million in the money supply.