For a financial system, the reserve ratio is 10% and the Fed decides to buy $5 million worth of bonds from the public. If the public deposits this amount into transactions accounts, what happens to the money supply initially and directly? What is the potential change in lending capacity (money creation) for the banking system?
For a financial system, the reserve ratio is 10% and the Fed decides to buy $5 million worth of bonds from the public. If the public deposits this amount into transactions accounts, what happens to the money supply initially and directly? What is the potential change in lending capacity (money creation) for the banking system?
The reserve ratio is 10% and the central bank is buying bonds. This would imply that the money supply increases. Now the first stage would be when the public deposits this $5 million in the bank. This would lead to an additional deposit of $5 million with banks. This would increase the potential lending capacity of banks.
Now the banks can lend 90% of this deposit, ie keeping 10% as a reserve, lend the rest of the money to the public, which means lending $4.5 million initially.
In the next stage, the public deposits $4.5 million in banks, and the bank after keeping 10% of it would lend the rest. This process continues till banks are getting deposits.
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