Consider an open market purchase by the Fed of $12 billion of Treasury bonds.

What is the impact of the purchase on the bank from with the Fed bought the securities?

Compute the impact on M1 assuming that (1) the required reserve ratio is 5%, (2) the bank does not wish to hold excess reserves, and (3) the public does not wish to hold currency.

The bank's securities _____ by $12 billion and its reserves _____ by $12 billion. Assuming that the required reserve ratio is 5%, banks do not want to hold excess reserves and the public does not wish to hold currency, the simple deposit multiplier will be _____ so the value of deposits (and M1) will rise by $_____ billion.

What is the impact of the purchase on the bank from which the Fed bought the securities?

The bank's cash assets increase by $12 billion while the bank's investments decrease by $12 billion.

Compute the impact on M1 assuming that (1) the required reserve ratio is 5%, (2) the bank does not wish to hold excess reserves, and (3) the public does not wish to hold currency.

The bank must set aside 5%, or $600,000,000. It can use the balance of $11,400,000,000 to make loans and earn money for the bank.

The bank's securities decrease by $12 billion and its reserves increase by $12 billion. Assuming that the required reserve ratio is 5%, banks do not want to hold excess reserves, and the public does not wish to hold currency, the simple deposit multiplier will be 20 so the value of deposits (and M1) will rise by $240 billion.

The formula for the money multiplier is this: money multiplier = 1/the reserve ratio. For this example that would be:

Money Multipler = 1/.05 = 20.