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20 July, 14:28

Suppose the required reserve ratio is 20 percent, and the Fed buys $1 million worth of bonds from the public. If the public deposits this amount into transactions accounts, the money supply will

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  1. 20 July, 14:42
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    Increase directly by $1 million and an additional lending capacity of $4 million will be created for the banking system.

    Explanation:

    The formula for increase in money supply is

    Increase in money supply = (1 / Required reserve ratio) * Excess reserve.

    Now, we have, required reserve ratio of 20%.

    That means, out of $1 million deposit, required reserve = ($1,000,000 * 0.20) = $200,000.

    Now, we knew that, Total reserve = required reserve + excess reserve

    Total Reserve = $1,000,000 and required reserve = $200,000.

    So, Excess reserve = $1,000,000 - $200,000 = $800,000.

    Now, Increase in money supply = (1 / 0.20) * $800,000 = $4 million.

    That means,

    If the public deposits this amount into transactions accounts, the money supply will:

    Increase directly by $1 million and an additional lending capacity of $4 million will be created for the banking system.
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