If banks wish to hold 20 percent of deposits in reserve and the Fed buys $100 billion in bonds, the M2 money supply could increase by as much as $______________ billion.
Money Multiplier tells us that how much money supply would change due to change in the amount of reserves. To calculate money multiplier, we will use the below formula:
Money Multiplier = 1 / Required reserve ratio
Given, Reserve ratio = 20%
Money Multiplier = 1 / 20% = 1 / 0.2 = 5
Money Multiplier = 5
To find the increase in the money supply, we will multiply money multiplier by the amount of money initially put by the fed.
So, when the Fed buys $100 billion of bonds, then the money supply could increase by as much as $500 billion i.e. 100*5.
Hence, the correct answer is $500 Billion.
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