Question

Suppose the Federal Reserve (Fed) wants to increase the money supply by $50 billion. Assume that the reserve requirement ratio is 10% and that banks do not hold any excess reserves. To increase the money supply by the desired amount, the Fed should:

a) Sell $50 billion worth of U.S. government bonds
b) Buy $50 billion worth of U.S. government bonds
c) Increase the reserve requirement ratio
d) Decrease the reserve requirement ratio

Answer 1

To increase the money supply by $50 billion, the Fed should buy $50 billion worth of U.S. government bonds.

Step-by-step explanation:

To increase the money supply by $50 billion, the Fed should buy $50 billion worth of U.S. government bonds. When the Fed buys bonds, it increases the reserves of the banks it buys from. Since the reserve requirement ratio is 10%, banks are required to hold 10% of their deposits as reserves. So when the reserves increase, the banks can lend out more money, which increases the money supply.