Question

In order to finance the 2018 budget deficit in Starland, the Treasury of Starland sold 25,000 5-year bonds with a value of 100 Stardollars each. The Central Bank bought 250,000 worth of bonds from the public. The required reserve ratio was 20 per cent in 2018 and there is no leakage of reserves out of the banking system. The combined effect of the Treasury sale and Central Bank purchase on the money supply in Starland is equal to

Select one:

a. a decrease of 1.25 million Stardollars.

b. an increase of 11.25 million Stardollars.

c. a decrease of 2.5 million Stardollars.

d. an increase of 1.25 million Stardollars

Answer 1

when the government sold the bonds the money supply decreased by the total value because the money came back to the central bank and people held the bonds only.

hence total decrease in money supply=100 stardollars eachx25000 bonds=2500000 stardollars

then central bank bought 250000 worth of bonds from the public and there is no leakage. hence the public will get that amount via demand deposits.

the reserve ratio is 20%

hence the total increase in money supply=250000+ 250000x(1-20%)+250000x(1-20%)2+250000x(1-20%)3+...........=250000(1/20%)=1250000

hence the net change in money supply=1250000-2500000=-1250000=-1.25 million star dollars

hence the correct answer is a.

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