Question

suppose the reserve requirement os 5 percent, banks keep no excess reserves and the currency in the hands of the non-bank public does not change.

a Suppose the central bank sells government securities to a commercial bank. will the money supply increase or decrease? why?

b.Calculate the change in the money supply if the central sells $1000 worth of government securities to a commercial bank.

Answer 1

a. If the Central Bank sells government securities to a commercial bank, then the money supply in the economy will decrease because in the open market, when the Central Bank sells government securities in the open market, it reduces the quantity of money supplied in the economy and thus the money supply declines and this leads to fall in the level of money supplied in the economy.

b. Change in money supply - 1 / Reserve Requirement * Worth of currecny sold

= 1/ .05 * $1000 = -$20,000

Thus, selling of $1000 worth of government securities will reduce the money supply in the economy by $20,000.