Assume that the reserve requirement is 5 percent. All other...

Assume that the reserve requirement is 5 percent. All other things being equal, will the money supply expand more if the Fed buys $\$$2,000 worth of bonds or if someone deposits in a bank $\$$2,000 that she had been hiding in her cookie jar? If one creates more, how much more does it create? Support your thinking.

Assume that the reserve requirement is 5 percent. All other things being equal, will the money supply
expand more if the Fed buys $\$$2,000 worth of bonds or if someone deposits in a bank $\$$2,000 that she had been hiding in her cookie jar? If one creates more, how much more does it create? Support your thinking.

Key Concepts

Reserve Requirement

The reserve requirement is the percentage of deposits that banks must hold and not lend out. It limits the amount of money that banks can create through the lending process by ensuring that a certain fraction of deposits is kept as reserves, thereby directly influencing the potential for money multiplication.

Money Multiplier

The money multiplier is a concept that quantifies how much the money supply can expand based on an initial injection of reserves. It is calculated as the reciprocal of the reserve requirement (e.g., 1/0.05 = 20 when the reserve requirement is 5 percent), meaning that every dollar of reserves can theoretically support up to 20 dollars of deposits through successive rounds of lending and depositing.

Open Market Operations

Open market operations refer to the central bank’s actions, such as buying or selling government bonds, to regulate the level of reserves in the banking system. When the Fed buys bonds, it injects reserves into the banking system, which can then be multiplied into a larger increase in deposits according to the money multiplier, thereby expanding the money supply.

Deposit Creation Process

The deposit creation process is the mechanism by which banks lend out a portion of their deposits while holding the required reserve fraction. As banks lend money, those funds tend to be redeposited in the banking system, leading to further rounds of lending. This cyclical process, bounded by the reserve requirement, results in a multiplied effect on the overall money supply.

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