Question

The banking system currently has $50 billion of reserves, none of which are excess. People hold only deposits and no currency, and the reserve requirement is 10 percent. lf the Fed raises the reserve requirement to 12.5 percent and at the same time sells $125 billion worth of bonds, then by how much does he money sup change?

a None of the above is correct.
b. It falls by $20 billion
c. It falls by $110 billion
d. It falls by $180 billion.

Answer 1

When the Fed increases the reserve requirement from 10% to 12.5% and also sells $125 billion in bonds, the money supply will decrease notably. Initially, the banking system with $50 billion in reserves can support $500 billion in deposits. With the new requirements and bond sales, reserves are insufficient, forcing a reduction in deposits and thereby contracting the money supply.

Step-by-step explanation:

Money Supply Change

To determine the impact on the money supply of a change in the reserve requirement and bond sales by the Fed, we follow a few steps. Initially, banks hold $50 billion in reserves, all required at a reserve ratio of 10%. With a reserve requirement of 10%, this implies that the total deposits are $500 billion (since 10% of $500 billion is $50 billion). When the reserve requirement is increased to 12.5%, the banks now need additional reserves to secure the same level of deposits. The new required reserves would be 12.5% of $500 billion, which is $62.5 billion. However, the Fed also sells $125 billion worth of bonds, which banks purchase by reducing their reserves by $125 billion.

This means the banking system is now short of $62.5 billion (from the increase in reserve ratio) + $125 billion (from the bond sales), totaling $187.5 billion. However, since banks had no excess reserves initially, they need to reduce deposits (by calling in loans or other means) to meet the new reserve requirements. The decrease in deposits caused by selling bonds would lead to a multiplier effect on money supply reduction. Since the banks' reserves would only cover $312.5 billion of deposits after these operations ($50 billion reserves - $125 billion + $12.5 billion additional reserves to meet the new requirement), the money supply can be expected to contract significantly.

Unfortunately, there is not enough information to calculate the change in money supply exactly, as it would depend on the money multiplier effect and behavior of the banking system. However, it is certain that the money supply would decrease by more than $125 billion.