Question

Using a required reserve ratio of 10% and if banks keep no excess reserves, which of the following scenarios produces a larger increase in the money supply, explain why. a) Someone takes $1000 from under his or her mattress and deposits it into a checking account. b) The Fed purchases $1,000 in government securities from a commercial bank.

Answer 1

Answer:

Given that

Reserve Ratio = 10% = 0.1

Money Multiplier,

a)

Someone takes $1000 from under his or her mattress and deposits it into a checking account.

Someone Deposited $1000 then Bank will keep 10% (= reserve ratio) that is 10% of $1000 = $100 (In the form of reserve this amount has to be kept by the bank)

and remaining amount will be available to the bank that is $900 (=$1000 -$100).

Since reserve ration is 10% therefore Money Multiplier will be 10.

Increase in the money supply = $900 * 10 = $ 9000

b)

The Fed purchases $1,000 in government securities from a commercial bank:

When Government buys securities from a Commercial bank worth $1000 .

The Government Purchase will go directly to the multiplier the increase in the money supply would be equal to

$1000 * 10 = $ 10,000.

Therefore, from above calculation we can conclude when Government buys securities from commercial bank then it produces larger increase on money supply.