Effects on Money Supply.

To understand the effect of the reserve change on the money supply, we must consider the banks’ response. In this chapter, we continue the algebraic convenience of assuming that banks hold .10 percent of their deposits as serves with the central bank the legal reason for this practice is discussed in greater detail later in this chapter.

What happens to the money supply? Reserves go down by 1 billion, and that tends to set off a contraction of deposits. The last chapter showed how a change in bank reserves would lead to a multiplied change in total bank deposits. If the legal reserve requirement is 10 percent, the $1 billion sale of government bonds will result in a $10 billion cut in the community’s money supply Table 26-2(b) shows the banks’ ultimate position after $1 billion of reserves have been extinguished by the open-market operation, In the end, the Fed’s open-market sale has caused a $10 billion contraction in the money supply.

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