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Written Assignment Unit 7

The document explains how an open-market purchase by the Federal Reserve can expand the money supply through the money multiplier effect. With a required reserve ratio of 0.2, a $2 billion bond purchase can potentially increase the money supply by $10 billion. Key assumptions include banks lending out all excess reserves and no currency leakage.

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16 views2 pages

Written Assignment Unit 7

The document explains how an open-market purchase by the Federal Reserve can expand the money supply through the money multiplier effect. With a required reserve ratio of 0.2, a $2 billion bond purchase can potentially increase the money supply by $10 billion. Key assumptions include banks lending out all excess reserves and no currency leakage.

Uploaded by

seraphmuinde
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Student - Chaw Sandi Aung

ECON 1580 - Introduction to Economics Unit 7 Written Assignment


Instructor - Dr. John Halstead
May 27, 2025

Expansion of the Money Supply Following an Open-Market Purchase

When the Federal Reserve (Fed) conducts an open-market purchase of bonds, it injects reserves
into the banking system. Assuming banks are "loaned up" (meaning they hold no excess
reserves), the money supply can expand through the money multiplier process. The maximum
potential increase in the money supply is determined by the money multiplier formula:

\[
\text{Money Multiplier} = \frac{1}{\text{Required Reserve Ratio (rr)}}
\]

Given a required reserve ratio (\( rr \)) of **0.2**, the money multiplier is:

\[
\text{Money Multiplier} = \frac{1}{0.2} = 5
\]

If the Fed purchases **$2 billion** worth of bonds, the initial increase in bank reserves allows
for a maximum expansion of the money supply by:

\[
\text{Change in Money Supply} = \text{Open-Market Purchase} \times \text{Money Multiplier}
\]
\[
= \$2 \text{ billion} \times 5 = \$10 \text{ billion}
\]

Thus, the money supply could expand by **$10 billion** as a result of this transaction.

Key Assumptions
This calculation assumes:
1. **Banks lend out all excess reserves** (no idle reserves).
2. **No currency leakage** (the public does not withdraw cash, keeping deposits within the
banking system).
3. **Banks are fully loaned up** before the Fed’s intervention.

If these conditions do not hold, the actual increase in the money supply may be smaller.

References
Board of Governors of the Federal Reserve System. (2023). *Monetary policy and the
economy*. Federal Reserve. https://www.federalreserve.gov

Mankiw, N. G. (2021). *Macroeconomics* (10th ed.). Worth Publishers.

*Note: APA 7 formatting requires a hanging indent for references, which may not display
correctly in plain text.*

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