Suppose that, for every 1-percentage-point decline of the discount rate, commercial banks collectively borrow an additional $2 billion from Federal Reserve Banks. Also assume that the reserve ratio is 20 percent. If the Fed increases the discount rate from 4.0 percent to
4)25 percent, bank reserves will
A) increase by $0.5 billion and the money supply will increase by $2.5 billion.
B) decline by $0.5 billion and the money supply will decline by $2.5 billion.
C) increase by $0.75 billion and the money supply will increase by $3.75 billion.
D) increase by $1 billion and the money supply will increase by $5 billion.

Question

Quizplus · Accepted Answer

According to the given assumptions, a 0.25 percentage-point increase in the discount rate will lead to a decrease in borrowing by commercial banks from Federal Reserve Banks by $0.5 billion (0.25*2). Since the reserve ratio is 20 percent, this decrease in borrowing will result in a decline in bank reserves by $0.1 billion (0.20*0.5). As a result, the money supply will decline by the same amount, which is $2.5 billion (0.1*25). Therefore, the correct choice is B.

Suppose That, for Every 1-Percentage-Point Decline of the Discount Rate