Question

Question 25 (12 points) Suppose the required reserve ratio is 5%. If the Fed sells $50 million worth of Treasury bonds, what will happen to the money supply? Describe any calculations made to support your answer. Based on your answer above, what will happen to interest rates in the bond market? Explain in detail how you came up with this response. Based on your answers above, what will happen to the federal funds rate? Explain in detail how you came up with this response. Paragraph В І I U The money supply will A/ El

Answer 1

25. The required reserve ratio = 5%. Therefore, the money multiplier = 1/required reserve ratio = 1/5% = 20.

If the Fed sells $50 million worth of treasury bonds, money supply will decrease in the economy. Money supply will decrease by $(50 million * money multiplier) = $(50 million * 20) = $1000 million.

As bond supply increases, price of bonds decreases. There is always an inverse relationship between bond interest rate and price of bonds. Therefore, in the bond market, interest rate increases.

As the money supply decreases, banks have less money to loan to other banks, Consumers and businesses. So, the federal funds rate (the interest rate at which commercial banks borrow and lend their excess reserve to each other overnight) is likely to increase.