Question

If the actual reserve ratio is 8%, the change in the money supply resulting from the Fed selling 10000 worth of bonds is:_________

Answer 1

When the Fed sells bonds and the reserve ratio is 8%, a bank that buys $10,000 worth of bonds has to adjust its loans to maintain the required reserves. Using the money multiplier, this can lead to a potential contraction in the money supply of up to $125,000.

Step-by-step explanation:

Impact of the Fed Selling Bonds on the Money Supply

When the Federal Reserve (Fed) sells bonds, the banks that purchase these bonds pay for them with their reserves. If a bank purchases $10,000 worth of bonds from the Fed, and the actual reserve ratio is 8%, this implies that the bank must maintain $800 in reserves for every $10,000 in deposits. However, this transaction would remove $10,000 from the bank's reserves, forcing the bank to adjust its loans and deposits to maintain the required reserve ratio.

In order to restore its reserves to the required level after the bond sale, the bank would need to reduce its loans. To calculate the full impact on the money supply, one would use the money multiplier formula. Since the reserve ratio is 8%, the money multiplier is 1 / 0.08, which equals 12.5. Therefore, for every dollar that the reserves decrease, the money supply could potentially contract by up to $12.5. So, a reduction of $10,000 in reserves could lead to a decrease of up to $125,000 in the money supply.

However, it's essential to note that this simplified calculation assumes that all other variables remain constant and that the money multiplier effect works to its maximum theoretical extent, which may not be the case in the real world due to factors like cash leakages and banks holding excess reserves.

Answer 2

The change in money supply resulting from the Fed selling $10,000 worth of bonds is a decrease, as the bank will need to reduce its loans by $10,000 to maintain the required reserve ratio, which in turn lowers the money supply according to the money multiplier effect.

Step-by-step explanation:

If the actual reserve ratio is 8%, the change in the money supply resulting from the Fed selling $10,000 worth of bonds is a decrease in the money supply. When the Fed sells bonds to a bank, the bank pays for these bonds with its reserves. Assuming the bank was holding just the required reserves before the sale, it would have to hold an additional $10,000 in reserves after purchasing the bonds. To maintain the required reserve ratio, the bank would need to reduce its loans by $10,000. Since loans contribute to the money supply, when a bank reduces its loans, the money supply decreases correspondingly. In this case, the reduction in loans would lead to a decrease in the money supply.

This process is known as the money multiplier effect, where changes in the base level of reserves in the banking system can lead to a multiplied effect on the overall money supply due to banks' lending activities.