Question

The Federal Reserve decides to sell $100 million in government debt to households paying with checkable deposits. The current reserve requirement is 20%.

Instructions: Enter your answer as a whole number.

a. The Fed's decision will lead to   (Click to select)   more   fewer   the same  reserves in the banking system and   (Click to select)   the same   fewer   more  checkable deposits.

b. The money supply will   (Click to select)   decrease   increase   remain the same  by a maximum of $   million.

Answer 1

Ans. Sale of government debt to households by the Central Bank is called open market sales. This is a contractionary monetary policy. So, it reduces money supply in the economy and as households will pay for the government debt with the amount in their checkable deposits, so, checkable deposits will decrease leading to decrease in reserves because reserve requirement is proportion of total checkable deposits.
Money multiplier = 1/(reserve requirement) = 1/0.20 = 5

The open market sale will decrease money supply from the economy as people will use money to pay for the government debt. So,

Decrease in money supply = multiplier * sale value = 5*$100 million = $500 million

Thus, the answers are,

a) Fewer reserves in the banking system and fewer checkable deposits.

b) The money supply will decrease by $500 million.

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