Suppose that the Federal Reserve ("the Fed") buys $5,000 of U.S. government bonds and the required reserve ratio is 0.10. If the assumptions of the simple money multiplier hold, this will __ the money supply by _
Which of the following assumptions is necessary for the simple money multiplier to be applicable?
1. The amount of cash people want to hold doesn't change when the money supply changes.
2. People's marginal propensity to consume does not rise with income.
3. Borrower default rates are stable.

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20-07-2020
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Suppose that the Federal Reserve ("the Fed") buys $5,000 of U.S. government bonds and the required reserve ratio is 0.10. If the assumptions of the simple money multiplier hold, this will __ the money supply by _
Which of the following assumptions is necessary for the simple money multiplier to be applicable?
1. The amount of cash people want to hold doesn't change when the money supply changes.
2. People's marginal propensity to consume does not rise with income.
3. Borrower default rates are stable.

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Answer:

If the assumptions of the simple money multiplier hold, this will INCREASE the money supply by $50,000.

The money multiplier = 1 / 0.1 = 10, so the increase in money supply = $5,000 x 10 = $50,000

Which of the following assumptions is necessary for the simple money multiplier to be applicable?

1. The amount of cash people want to hold doesn't change when the money supply changes.

One of the most serious problems with the money multiplier theory is that many of the assumptions that it requires do not always exist in real life. E.g. banks generally do not loan all the total loanable funds that they have. Or that debtors will spend all their credit immediately.