The reserve ratio is 20 percent. The Fed buys $1 million in government securities from a...

The reserve ratio is 20 percent. The Fed buys $1 million in government securities from a bond dealer by transmitting the funds to the dealer's deposit account at Bank A. Bank A makes the maximum loan possible to a construction company, which buys materials with the loan. The check is deposited in Bank B, which loans out all it can to a car dealership. To this point, the money supply has increased by.. A)$1 million B)$1.8 million C)$2.44 million D)$3 million.

Solutions

Expert Solution

Fed has paid $1 million to the dealer.

Dealer has deposited $1 million at his deposit account with Bank A.

Reserve ratio is 20%.

Required reserves maintained by Bank A = $1 million * 0.20 = $200,000

Excess reserves created by new deposit = Deposit - Required reserves = $1 million - $200,000 = $800,000

Bank A loans out these entire excess reserves to a construction company.

Construction buys material with loan and pay by check which the supplier deposits into Bank B.

Deposit created at Bank B = $800,000

Required reserves to be maintained = $800,000 * 0.20 = $160,000

Excess reserves with bank = $800,000 - $160,000 = $640,000

These excess reserves were loaned out to a car dealership. When bank makes a loan, it opens a deposit account in the name of borrower.

So, upto this point, three times deposit has increased. Deposit accounts are part of money supply. So, money supply will increase by the amount of increase in deposits.

Increase in deposits = $1 million + $800,000 + $640,000 = $2.44 million

So, money supply will increase by $2.44 million.

Hence, the correct answer is the option (C).

Rahul Sunny answered 2 years ago

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