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WA7- Money Supply Expansion

Statement

Assume that the banking system is loaned up and that any open-market purchase by the Fed directly increases reserves in the banks. If the required reserve ratio is 0.2, by how much could the money supply expand if the Fed purchased $2 billion worth of bonds?

Answer

Bonds are a promise by the issuer to pay the owner of the bond a payment or a series of payments on a specific date or dates. The Federal Reserve (Fed) buys and sells bonds in the open market to control the money supply. When the Fed buys bonds, it increases the money supply, and when it sells bonds, it decreases the money supply as it collects money from the buyers of the bonds and takes it out of circulation (Rittenberg & Tregarthen, 2009).

A fractional reserve system is a banking system where banks keep a fraction equals to the required reserve ratio of deposits as reserves and loan out the rest which named as the excess reserves. Giving the bank the ability to loan out the excess reserves expands the money supply and allows for re-using the money in other productive activities or investments which defines the notion of creating money (Rittenberg & Tregarthen, 2009).

The money creation, or the supply expansion, is controlled by the money multiplier which is the reciprocal of the required reserve ratio. The money multiplier allows for estimating the amount of money that can be created from an initial purchase; it is given by the formula (Khan Academy, 2018):

\[ \text{Money Supply Expansion} = \frac{1}{\text{Required Reserve Ratio}} \times \text{Initial Purchase} \]

Given that the required reserve ratio is 0.2 and the initial purchase is $2 billion, the money supply expansion is:

\[ \text{Money Supply Expansion} = \frac{1}{0.2} \times 2 = 5 \times 2 = 10 \]

Thus, the Fed purchasing $2 billion worth of bonds could expand the money supply by $10 billion.

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