Question

If the Fed carries out an open market sale of $3,000 in U.S. Treasury Bonds with a 5% reserve requirement ratio and excess reserves of $2,850. The money supply will be which of the following?

1. A decrease of $57,000.

2. An increase of $60,000.

3. An increase of $36,000.

4. A decrease of $47,700.

Answer 1

We know that Money Multiplier = Monetary Base/ (cash deposit ratio + excess deposit ratio + required reserves ratio)

Now we know that since it is an open market sale, there will be a negative change in monetary base, hence there will be a decrease in money supply. We, therefore, eliminate options 2. and 3. Now, looking at option 1 and 4.,

Now, money supply = -3000/(0.05+excess reserves ratio + cash to deposit ratio)

If we take both excess reserves and cash to deposit ratio to be 0, then the answer would be a decrease of 60,000.

Now, since it's given that there is an excess reserve held by the bank, the minimum we take this to be at 1%.

Then the Money supply will be 50,000.

Thus, the answer has to be less than 50,000. We will eliminate option 1. as well, and thus the answer is option 4.