Question

5) The Federal Reserve sells $400 in bonds to Bank of America. Show the changes in the balance sheets for the Fed and B of A. What is the change in the monetary base? If the reserve requirement is 5%, what is the maximum change in the money supply? Explain briefly.

Answer 1

5. If the Fed sells $400 in bonds then there will be an addition of money by $400 which will be paid by Bank of America and the balance sheet of B of A will show a deduction of capital inflow or the existing capital.

When the Fed sells bonds, the dollars that it receives to from the Bank of America decrease the monetary base and this, in turn, decrease the money supply.  It decreases the money supply by removing cash from the economy in exchange for bonds. Therefore, OMO has a direct effect on the money supply. OMO also affects interest rates because if the Fed buys bonds, prices are pushed higher and interest rates decrease; if the Fed sells bonds, it pushes prices down and rates increase.

If the reserve requirement is 5% and the bank receives a deposit of $400, it can lend out $380 of the deposit as it is only required to hold $20, or 5%. If the reserve ratio is increased, the bank is left with less money to lend out on each dollar deposited. Hence the maximum change in money would be $20.