Commercial Banks, the Federal Reserve, and the Creation of Money

The money supply is determined by the amount of currency and bank deposits held by the public, as well as the amount of reserves held by banks. The Federal Reserve, by buying and selling government bonds, can change the level of bank reserves in the banking system, which in turn leads to changes in deposits and the money supply.

Exploration: How does the Federal Reserve change the money supply?

The applet above allows you to see the effects of Federal Reserve purchases and sales of government bonds on deposits and the money supply. You can change the amount of the purchase or sale (Initial Change in Reserves) as well as banks' desired reserve-deposit ratio. By clicking on the Money Creation button, you can see the bank-by-bank effect of the Federal Reserve action on bank deposits, lending, and the money supply, as well as the ultimate change in the money supply after all lending rounds are completed. Click the Reset button to restore the original values.

1. If the Federal Reserve buys $10,000 in government bonds, what happens to the money supply, assuming the desired reserve-deposit ratio remains at 0.1?
   
   
2. If the Federal Reserve buys $20,000 in government bonds, what happens to the money supply, assuming the desired reserve-deposit ratio remains at 0.1?
   
   
3. If the Federal Reserve sells $15,000 in government bonds, what happens to the money supply, assuming the desired reserve-deposit ratio remains at 0.1?
   
   
4. If the Federal Reserve buys $10,000 in government bonds, but the banks' desired reserve-deposit ratio rises to 0.2, what happens to the money supply? How does the result differ if the desired reserve-deposit ratio remains at 0.1?
   
   
5. If the Federal Reserve sells $20,000 in government bonds, but the banks' desired reserve-deposit ratio falls to 0.05, what happens to the money supply? How does the result differ if the desired reserve-deposit ratio remains at 0.1?
   
   
6. When the Federal Reserve buys or sells government bonds, the money supply changes by a multiple of the initial change in reserves. Why does a Federal Reserve purchase or sale of government bonds lead to a larger change in the money supply?

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