Question

Bank A sells $10 million dollars of U.S. Treasury Securities to the Federal Reserve for $10 million dollars. Before the sale Bank A had no excess reserves but did meet its required reserve requirement. What is the impact of this sale on the supply of M1 if the bank lends out the entire $10 million to various businesses in New York? Do you think the supply of money will increase by more than $10 million? Why?

Answer 1

Answer - Due to this sale of securities by the commercial bank , it will have more funds to lend as it will gain the excess reserve now. Hence the money supply will definately rise. The quantity of rise in money supply will be more than the $ 10 million. This is because of functioning of money multiplier. Suppose if the Bank maintained reserve ratio of 20 % , the money multiplier will be 1/0.20 = 5

Hence M1 will rise by 10*5 = $ 50 million. Hence the increase in the money supply will be more than $ 10 million because of the multiplier effect in the economy.