Suppose the money supply is currently $500 billion and the Fed wishes to increase it by $100 billion.  Given a required reserve ratio of 0.25, what should it do?

Expert Answers

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To affect the total money supply, you can use a simple formula.

Change in total money supply divided by money multiplier equals the change in necessary reserves.

The money multiplier is the inverse of the reserve ratio, so to calculate that, divide 1 by the reserve ratio.

1 / 0.25 = 4, which is the money multiplier. If you plug that value into the above equation, it looks like so:

100 billion (change in total money supply) / 4 (money multiplier) = 25 billion (change in necessary reserves).

In order to increase the total supply of money in circulation, the reserve will need to increase its funding by $25 billion. In the open market, the Fed can buy government securities total $25 billion, which would infuse that liquid cash into the market and deposit it into banks, giving them enough available capital to cover the increase in total money supply.

A reserve ratio of 0.25 means that banks have to keep 25% of all deposits. A high reserve ratio normally means that the government wants to control...

(The entire section contains 3 answers and 510 words.)

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