Question

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.

Answer 1

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.