Question

Suppose the Fed bought $150 million of U.S. securities from security dealers. The reserve requirement is 20 percent, and there are no initial excess reserves. A few weeks later, if the public's holdings of currency are constant and the banks have loaned all excess reserves. the money supply will increase by:
A) $150 million
B) $750 million
C) $600 million
D) $300 million

Answer 1

The Fed has bought $150 million of US securities.

This will increase the reserves with banks by $150 million.

When Fed purchase securities then excess reserves are created.

So, excess reserves worth $150 million are created by this action of bank.

All the excess reserves can be used for lending.

Reserve requirement = 20% or 0.20

Money multiplier = 1/Reserve requirement = 1/0.20 = 5

The money multiplier is 5.

Calculate the increase in money supply -

Increase in money supply = Excess reserves created * Money multiplier

Increase in money supply = $150 million * 5 = $750 million

Thus,

The money supply will increase by $750 million.

Hence, the correct answer is the option (B).