what would happen to the money supply if the federal reserve made an open market sale of 5 million worth of gov't securities to a private citizen? assume that the bank with which this private citizen does business with is all loaned up, has reserves of 20 million dollars, deposits of 100 million dollars and must follow a required reserve policy of 20%
A "Bernadette" posted (almost) this same question on Sunday, Oct 15. See my response.
To determine the impact on the money supply, we need to analyze the various components involved. Let's break down the situation step by step:
1. The Federal Reserve makes an open market sale of $5 million worth of government securities to a private citizen.
In this scenario, the private citizen is purchasing government securities directly from the Federal Reserve. As a result, the private citizen pays $5 million to the Federal Reserve and receives the government securities in return.
2. The bank with which the private citizen does business is fully loaned up, has reserves of $20 million, deposits of $100 million, and a required reserve policy of 20%.
Here we have information about the bank's current state. "Fully loaned up" means that the bank has lent out all the available funds from its deposits to borrowers and does not have any additional funds to lend out.
According to the required reserve policy, the bank is required to hold 20% of its deposits as reserves. Therefore, the required reserves for this bank would be 20% of $100 million, which equals $20 million.
Now, let's analyze the impact on the money supply:
- When the private citizen purchases the government securities for $5 million, the private citizen transfers $5 million from their bank account to the Federal Reserve. This reduces the bank's reserves.
- Since the bank is fully loaned up, it cannot lend out any additional funds. Therefore, the bank's loans and deposits remain unchanged.
- The reduction in reserves affects the ability of the bank to create new money through the lending process. The money supply is based on the bank's ability to lend out a portion of its deposits.
- Given that the bank has a required reserve ratio of 20%, it means that the bank must hold $20 million as reserves. In this case, the bank's reserves would fall from $20 million to $15 million ($20 million - $5 million).
- As a result, the money supply would decrease by the same amount as the reduction in reserves. In this case, the money supply would decrease by $5 million.
Therefore, if the Federal Reserve made an open market sale of $5 million worth of government securities to a private citizen, the money supply would decrease by $5 million.