Question 71

To increase the money supply by +$5 billion with a 10% reserve requirement, the Fed should buy $50 million in bonds.

In order to achieve the desired increase in the money supply, the Federal Reserve must consider the reserve requirement ratio. With a 10% reserve requirement, buying $50 million in bonds will effectively increase the money supply by $5 billion due to the money multiplier effect.

A) Buy $50 m bonds

Buying $50 million in bonds is the correct choice because, with a 10% reserve requirement, this purchase will lead to a total increase in the money supply of $5 billion. The money multiplier is calculated as the inverse of the reserve requirement (1/0.10), which equals 10. Therefore, $50 million multiplied by 10 results in an increase of $500 million in the money supply, aligning with the Fed's objective.

B) Sell $50 m bonds

Selling $50 million in bonds would decrease the money supply rather than increase it. This action would take liquidity out of the banking system, leading to a contraction in the overall money supply, which is contrary to the Fed's goal of increasing it by $5 billion.

C) Buy $500 m bonds

While buying $500 million in bonds would indeed increase the money supply, it would exceed the target set by the Fed. With a 10% reserve requirement, purchasing this amount would result in an increase of $5 billion, which is excessive compared to the intended $5 billion increase.

D) Buy $5 bn bonds

Buying $5 billion in bonds would drastically overshoot the goal of increasing the money supply by only $5 billion. This action would lead to an enormous increase in the money supply that could destabilize the economy and is therefore not a viable option for the Fed.

Conclusion

The optimal strategy for the Federal Reserve to achieve a $5 billion increase in the money supply with a 10% reserve requirement is to buy $50 million in bonds. This choice effectively utilizes the money multiplier to reach the desired target without overshooting or contracting the money supply, unlike the other options which either misinterpret the multiplier effect or counteract the intended policy.