The Fed buys $20 million of securities from AIG, the desired reserve ratio is 0.

Question

The Fed buys $20 million of securities from AIG, the desired reserve ratio is 0.2, and there is no currency drain.

As soon as the open market purchase is made, the bank's excess reserves are $_____ million.

The maximum amount of loans that the banking system can create is ______, and the maximum amount of new money that it can create (not including the original deposit from AIG) is ______.

A. $80 million; $80 million

B. $100 million; $80 million

C. $100 million; $100 million

D. $80 million; $100 million

Explanation / Answer

B) We know excess reserves = actual reserves - desired reserves.

The new reserves created bythe Fed's purchase sre $20 million. Desired reserves have not changed.

So Excess reserves are 20 - 0 = $20million.

The maximum amount of loan that the banking system can make is equal to the increase in the quantity of money. To calculate the increase in the quantity of money, use the money multiplier.

1 + (C/D) / (R/D+C/D)

C/D is the currency drain ratio and R/D is the desired reserves ratio. In this case the currency drain ratui = 0 . So the money multiplier is 1 / 0.2 = 5. So the total increase in the quantity of money is (5*20) = $100 million. Given the $100 million increase in quantity of money,the total increase in loans is $100million.

And the maximum amount of new money that can create is (100 - 20) = $80million.

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