Question

The banking system currently has $100 billion of reserves, none of which are excess. People hold only deposits and no currency, and the reserve requirement is 10 percent. If the Fed lowers the reserve requirement to 8 percent and at the same time buys $10 billion worth of bonds, then what is the maximum amount the money supply can change?

a. It rises by $300 billion. b. It rises by $125 billion. c. It rises by $375 billion. d. None of the above is correct.

Answer is C. Why?

Answer 1

Answer: C. It rises by $375 billion

Reserve requirement decreases from 10% to 8% and excess reserve increase by 2% (10%-8%) of total deposits.

Banking system with $100 billion of reserves and a reserve requirement of 10% = 100/0.1 = $1000 billion

Total deposit = $1000 billion

Excess reserve increases by 2% of total deposit

2% * $1000 billion = $20 billion

Change in base = Purchase of bonds + Increase in excess reserve

Change in base = $10 billion + $20 billion = $30 billion

Maximum amount the money supply can change = Change in base/Reserve Ratio

= $30/0.08

= $375 billion