Question

Suppose that the money multiplier here in the U.S has been estimated to be 2.5. If the Federal Reserve wants to increase the money supply to $1500, it should:

a. sell government bonds worth $600

b. buy government bonds worth $600

c. raise the discount rate by 2%

d. raise the required reserve ratio to 0.2

Answer 1

Correct option - (b) buy government bond worth $600

As we know,

Money supply = multiplier × high powered money.

As in the above case multiplier is 2.5 therefore to increase the money supply to $1500. Government bond of worth $600 should be buyed.

Money supply/multiplier = high powered money

= $1500/2.5 = $600 = high powered money.

When central bank will buy government bond of worth $600. It pays in form of deposit in central bank. Which will further increase the money supply with the help of multiplier.