Question

Microeconomics

Posted 3 months ago

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The reserve requirement in Florin is $20 \%$. The Central Bank of Florin buys $\$ 2,000$ worth of bonds using open market operations.
Which of the following describes the impact of the open market purchase of bonds on the monetary base and the money supply?
Choose 1 answer:
(A) The monetary base increases by less than $\$ 2,000$; the money supply increases by at least $\$ 10,000$
(B) The monetary base increases by exactly $\$ 2,000$; the money supply increases by exactly $\$ 10,000$
(C) The monetary base increases by exactly $\$ 2,000$; the money supply increases by up to $\$ 10,000$
(D) The monetary base increases by at least $\$ 2,000$; the money supply increases by at least $\$ 10,000$
(E) The monetary base increases by less than $\$ 2,000$; the money supply increases by up to $\$ 10,000$
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Answer from Sia

Posted 3 months ago

Solution

a

Reserve Requirement: The reserve requirement in Florin is $20\%$. This means that banks must hold 20% of their deposits as reserves

b

Open Market Operations: The Central Bank of Florin buys $2,000$ worth of bonds. This action increases the monetary base by exactly $2,000$

c

Money Multiplier: The money multiplier ($m$) is calculated as $\frac{1}{\text{reserve ratio}}$. Given a reserve ratio of $20\%$, the money multiplier is $m = \frac{1}{0.20} = 5$

d

Impact on Money Supply: The increase in the monetary base by $2,000$ will lead to an increase in the money supply by $2,000 \times 5 = 10,000$

Answer

(B) The monetary base increases by exactly $2,000$; the money supply increases by exactly $10,000$

Key Concept

Open Market Operations and Money Multiplier

Explanation

When the central bank buys bonds, it increases the monetary base by the exact amount of the purchase. The money supply increases by the product of the monetary base increase and the money multiplier.

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