Suppose the Federal Reserve System has a required reserve ratio of 10% and there are no...

Suppose the Federal Reserve System has a required reserve ratio of 10% and there are no excess reserves in the system. Explain the impact of the following action:

The Federal Open Market Committee conducts an open market purchase of $25 million of U.S. securities from the commercial banking system.

Identify the impact on both the Money Supply and on Aggregate Demand. Be specific.

Expert Solution

The required reserve ratio RR is 10% which means 10% of checkable deposits should be kept as required reserves either at the bank or at the Fed. Now there is an open market purchase of government securities worth $25 million.

This is an increase in monetary base which increases deposits of the banking system by $25 million. Using the simple deposit multiplier of 1/RR = 1/10% = 10, this implies that there will be a total of 25*10 = $250 million created as money in the economy when these deposits (after keeping 10%) are extended as loans. Hence, money supply would increase by $250 million.

As money supply is increased rate of interest is reduced that stimulates investment spending and thus, aggregate spending. Thus, AD increases and AD shifts to the right, raising the output level and the price level in the short run.

Rahul Sunny answered 1 year ago

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