The Federal Reserve injects $2 million of excess reserves by buying bonds from its primary dealers. There is a 7% reserve ratio and if all the assumptions of the simple money multiplier are in place, then the maximum amount of money created by this transaction will be how many millions of dollars?

If the answer is $100 million then use 100 for your response.

Question

The Federal Reserve injects $2 million of excess reserves by buying bonds from its primary dealers.  There is a 7% reserve ratio and if all the assumptions of the simple money multiplier are in place, then the maximum amount of money created by this transaction will be how many millions of dollars?

If the answer is $100 million then use 100 for your response.

BlackTom AI · Accepted Answer

The problem involves the simple money multiplier concept. 
First, recall that the simple money multiplier is given by 1 / reserve ratio. Here, the reserve ratio is 7%, or 0.07 as a decimal. 
Second, compute the multiplier: 1 / 0.07 ≈ 14.2857. This tells us that for every initial dollar of reserves added to the banking system, up to about 14.29 dollars can be created in checkable deposits through the process of multiple loan repayments and re-loans. 
Third, apply the multiplier to the initial increase in reserves. The Fed injects excess reserves of $2 million, so the total potential increase in the money supply is 2 million × 14.2857 ≈ 28.5714 million. 
Fourth, interpret the result in the requested units. Since the question asks for the amount in millions of dollars, we report approximately 28.57 million dollars. 
Takeaways: with a reserve ratio of 7%, the money multiplier is about 14.29, and a $2 million reserve injection can generate roughly $28.57 million in the money supply through the banking system, under the simple money multiplier assumptions.

ECON 201 Sections 2 & 3, Winter 2025 practice final exam question set

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