Question

Let's say that the Federal Reserve purchases $1 Million worth of U.S. Treasury bonds from a bond dealer in the open market, and the dealer's bank credits the dealer's account. The required reserve ratio is 15 percent, and the bank typically lends any excess reserves immediately. a) Assuming that no currency leakage occurs, how much will the bank be able to lend to its customers following the Fed's purchase? Please explain and show your calculations. b) Using the simple money multiplier, how much money will be created (assuming every dollar is lent out)? Please explain and show your calculations.

Answer 1

a) The fed has required reserve ratio as 15% which implies that 15% of the deposits needs to be reserved and rest lended. Now since there is no currency leakage , the bank lends the rest of the amount as loans.

The amount lended to borrowers is (1-0.15)*$1 million

= 0.85*$1 million =0.85 million

So the bank could lend 0.85 million $ owing to the 15% reserve ratio it has to maintain

b) The formula for simple Money multiplier is given by

1/r*(new deposit) = 1million *(1/0.15) = 6.67 million $.

So the money created from the deposits of$1 million is $ 6.67 million.

(You can comment for doubts)