Question

The reserve ratio is 20 percent. The Fed buys $1 million in government securities from a bond dealer by transmitting the funds to the dealer's deposit account at Bank A. Bank A makes the maximum loan possible to a construction company, which buys materials with the loan. The check is deposited in Bank B, which loans out all it can to a car dealership. To this point, the money supply has increased by.. A)$1 million B)$1.8 million C)$2.44 million D)$3 million.

Answer 1

Answer:

B)$1.8 million

Explanation:

We have the following events:

• Fed buys $1 million in securities and this money is deposited as reserves in Bank A.
• Bank A leads the maximum of $800,000 (the reserve ratio is 20% percent, so at least 20% of the money at the bank must be kept as reserve) to a construction company, and keeps $200,000 in reserve.
• Bank B gets the $800,000 check from the construction company, keeps $160,000 in reserves and loans out the rest to a car delearship.

The money supply to this point has increased by:

$200,000 kept in reserve by Bank A

$800,000 loaned out by Bank A

$160,000  kept in reserve by Bank B

$640,000 loaned out by Bank B

= $1,800,000 Total increase in the money supply

The answer is B)