Question

Assume a country's banking system has limited reserves. Suppose that the central bank buys $400 billion worth of

government securities from the public. If the required reserve ratio is 20 percent, the maximum increase in the
money supply is
(A) $1,600 billion
(B) $1,800 billion
(C) $2,000 billion
(D) $2,200 billion
(E) $2,400 billion

Answer 1

The correct answer is (C) $2,000 billion, which is the result of multiplying the initial $400 billion by the money multiplier of 5, derived from the 20 percent reserve requirement.

Step-by-step explanation:

When the central bank of a country purchases government securities from the public, it effectively injects liquidity into the banking system. Given that the required reserve ratio is 20 percent, the banking system can multiply the initial increase in reserves through the money creation process, often represented by the money multiplier formula. In this case, the money multiplier is 1 divided by the required reserve ratio, which is 1 / 0.20, equaling 5. Therefore, the maximum increase in the money supply, using the money multiplier effect, would be the initial injection of reserves multiplied by the money multiplier. Specifically:

• Initial increase in reserves from purchase of securities: $400 billion
• Money multiplier: 5
• Maximum increase in the money supply: $400 billion * 5 = $2,000 billion

The correct answer is (C) $2,000 billion, indicating that the central bank's purchase of $400 billion in government securities can theoretically lead to a maximum increase of $2,000 billion in the money supply, given a 20 percent required reserve ratio.

Answer 2

(C) $2,000 billion.

Step-by-step explanation:

The maximum increase in the money supply is determined by the money multiplier formula, which is:

money multiplier = 1 / reserve requirement

In this case, the reserve requirement is 20%, or 0.2, so the money multiplier is:

money multiplier = 1 / 0.2

= 5

This means that for every dollar of reserves, the banking system can create up to $5 of new money. Since the central bank bought $400 billion worth of government securities, this means that the banking system now has an additional $400 billion in reserves that it can use to create new money. Therefore, the maximum increase in the money supply is:

maximum increase in money supply = money multiplier x increase in reserves

= 5 x $400 billion

= $2,000 billion

Therefore, the answer is (C) $2,000 billion.