Question

The banking system currently has $200 billion of reserves, none of which are excess. People hold only deposits and no currency, and the reserve requirement is 4 percent. If the Fed raises the reserve requirement to 10 percent and at the same time buys $50 billion worth of bonds, then by how much does the money supply change?

a. It rises by $600 billion.
b. It rises by $125 billion.
c. It falls by $2,500 billion.
d. None of the above is correct.

Answer 1

When the Federal Reserve raises the reserve requirement and buys bonds, the money supply increases by the amount of bonds purchased.

Step-by-step explanation:

The question asks how the money supply changes when the reserve requirement is increased and bonds are bought by the Fed. To answer this, we need to consider the initial condition and the changes that occur. Initially, the banking system has $200 billion of reserves, none of which are excess. The reserve requirement is 4 percent.

First, the Fed raises the reserve requirement to 10 percent. This means that banks would need to increase their reserves. Since the banking system has no excess reserves, banks would need to reduce their loans and deposits to meet the new reserve requirement.

Second, the Fed buys $50 billion worth of bonds. When the Fed buys bonds, it pays for them by crediting the accounts of the sellers, which increases their deposits. This injection of money into the banking system increases reserves, allowing banks to meet the new reserve requirement without further reducing loans and deposits.

Therefore, the money supply increases by the amount of bonds purchased by the Fed, which is $50 billion. So the correct answer is b. It rises by $125 billion.