Suppose the Fed decides to increase the money supply. It purchases a government bond worth $2,000 from Antonia, a private citizen. Antonia deposits the check in her account at First National Bank. Supposed the required reserve ratio is 0.2 (20%).

(a) Trace the effect of this change through three banks - First National, Second Federal, and Third State.

(b) How much money will be generated in this banking system?

(a) Trace the effect of this change through three banks - First National, Second Federal, and Third State.

Antonia deposits $2,000 in First National Bank.

Then First national Bank lends $1,600 to client X that uses the money to purchase something. The seller of that something deposits the money In Second Federal Bank.

Second Federal Bank then lends $1,280 to client Y that decides to use that money to pay his rent. Client Y's landlord then deposits the money in Third State Bank.

Third State Bank will then lend $1,024 to client Z ...

(b) How much money will be generated in this banking system?

total money generated in the banking system = Antonia's deposit x money multiplier

money multiplier = 1 / required reserve rate = 1 / 0.2 = 5

so the total money generated = $2,000 x 5 = $10,000