Question

If the Fed sells $3 million of bonds to the First National Bank, what happens to reserves and the monetary base? What will be the overall effect on the money supply? Using T-accounts show at least three steps in the deposit creation process.
Assume that the required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change.

Answer 1

If the Fed sells $3 million of bonds to the First National Bank and the required reserve ratio on checkable deposits is 10%,

Assume that banks do not hold any excess reserves, and the public’s holdings of currency do not change.

The reserves and monetary base rises by $3 million

Money supply= initial amount x money multiplier = $3 million x 1/reserve ratio=  $3 million x 1/10%= $30 million

Assets	Liabilities
Reserves $3 million	Deposits $3 million

In 1st stage:

Assets	Liabilities
Reserves $300000	Deposits $3 million
Loan $2.7 million

In 2nd stage:

Assets	Liabilities
Reserves $2.7 million	Deposits $2.7 million

Assets	Liabilities
Reserves $270000	Deposits $2.7 million
Loan $2.43million

In 3rd stage:

Assets	Liabilities
Reserves $2.43 million	Deposits $2.43 million

Assets	Liabilities
Reserves $243000	Deposits$2.43 million
Loan $2.187 million