Suppose that the Fed purchases from bank A some bonds in the open market and tha

Question

Suppose that the Fed purchases from bank A some bonds in the open market and that, before the sale of bonds, bank A had no excess reserves.

a) Describe what initially happens to the reserves of bank A.

b) If bank A does not want to hold excess reserves, what will it do with the additional money received from the sale of bonds to the Fed?

c) Why do we expect, at least in usual times, that the amount of checking deposits in the economy will go up?

d) Now suppose that the minimum required reserve ratio for banks is 1/10. Also suppose that banks hold no excess reserves and that currency in circulation is unchanged from the purchase of bonds. If the Fed buys $20 billions of bonds from bank A, what will be the increase in checking deposits?

Explanation / Answer

(a) This transaction will lead to a positive balance on the Reserves of bank A.

(b) If bank A doesn't want to hold excess reserves, it will lend the total amount of reserves to borrowers.

(c) When a borrower takes a loan from bank A, they deposit partial or full amount of the loan in another bank, which is a checking account. So, total checking deposits increase.

(d) Increase in checking deposits = Increase in total money supply in the economy

= Fed purchase of bonds / Required reserve ratio

= $20 billion / (1/10) = $20 billion / 0.1

= $200 billion

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