Question

Suppose the money supply (as measured by checkable deposits) is currently $400 billion. The required reserve ratio is 25%. Banks hold $100 billion in reserves, so there are no excess reserves. The Federal Reserve ("the Fed") wants to increase the money supply by $18 billion, to $418 billion. It could do this through open-market operations or by changing the required reserve ratio. Assume for this question that you can use the oversimplified money multiplier formula.

Answer 1

Answer:

1) To increase money supply by open market operations, Fed should buy $7 billion of government securities.

2) To increase money supply by adjusting reserve ratio, Fed should decrease the required reserves ratio.

Explanation:

The Money multiplier = 1 / Required reserves ratio = 1 / 0.25 = 4

1) To increase money supply by open market operations, Fed should Sell $7 billion of government securities.

( money supply increase by $4. So, to increase money supply by $35 billion, government securities to be sold to the amount of $18 billion / 4 = $4,5 billion)

(2) To increase money supply by adjusting reserve ratio, Fed should decrease the required reserves ratio.