Suppose the Fed purchases a $1,000 government bond from you. If you deposit the entire $1,000 in your bank, what is the total potential change in the money supply as a result of the Fed's action if reserve requirements are 20 percent?

Question

a. $4,000
b. $5,000
c. $1,000
d. $0

Answer 1

To determine the total potential change in the money supply as a result of the Fed's action, we can use the money multiplier formula, which is given by:

\[ \text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}} \]

In this case, the reserve requirement is 20%, or 0.20. So, the money multiplier would be:

\[ \text{Money Multiplier} = \frac{1}{0.20} = 5 \]

Now, since the Fed purchases a $1,000 government bond from you and you deposit the entire amount in your bank, the initial increase in the bank reserves is $1,000. The total potential change in the money supply can be calculated by multiplying the initial deposit by the money multiplier:

\[ \text{Total Potential Change in Money Supply} = \text{Initial Deposit} \times \text{Money Multiplier} \] \[ = 1,000 \times 5 = 5,000 \]

Thus, the total potential change in the money supply as a result of the Fed's action is $5,000.

The correct answer is b. $5,000.