Metropolis National Bank is holding 2% of its deposits as excess reserves. Assume that no banks in the economy want to maintain holdings of excess reserves and that people only hold deposits and no currency. The Fed makes open market purchases of $10,000. The person who sold bonds to the Fed deposits all the funds in Metropolis National Bank. If the bank now loans out all its excess reserves, by how much will the money supply increase? A. $190,000 B. $200,000 C. $240,000 D. None of the above are correct.

A) $190,000

Explanation:

First we must determine the reserve ratio and the amount of excess reserves.

Assets Liabilities

Reserves $60,000 Deposits $500,000

Loans $440,000

If the bank is holding 2% of its deposits as excess reserves, the total amount of excess reserves = $500,000 x 2% = $10,000

Required reserves = total reserves - excess reserves = $60,000 - $10,000 = $50,000

If required reserves are $50,000, they represent a 10% reserve ratio ( = $50,000 / $500,000).

If the reserve ratio is 10%, the money multiplier = 1 / 10% = 10

Since $10,000 were deposited by a client and the bank decides to loan all of its excess reserves, it will loan: $70,000 - ($510,000 x 10%) = $70,000 - $51,000 = $19,000

If the bank loans $19,000 and the money multiplier is 10, the money supply will increase by $190,000 ( = $19,000 x 10)