If the Fed buys $10,000 of bonds and the required reserve ratio is 8%, what could happen to the money supply at most?

When the Federal Reserve purchases bonds, it injects money into the banking system, which can lead to an increase in the money supply through the money multiplier effect. The required reserve ratio indicates the fraction of deposits that banks must hold as reserves and not lend out.

In this scenario, with a reserve ratio of 8%, this means that banks can lend out 92% of the deposits they receive. The money multiplier, which determines how much the total money supply can increase from an initial injection of money, is calculated as the reciprocal of the reserve ratio. In this case, the money multiplier is 1 / 0.08, which equals 12.5.

By purchasing $10,000 worth of bonds, the Fed adds this amount to the reserves of the banking system. As banks lend out money, the initial deposit can lead to a larger increase in the total money supply. The initial increase of $10,000 can be multiplied by the money multiplier of 12.5 to determine the maximum potential increase in the money supply:

$10,000 x 12.5 = $125,000.

Thus, the most significant increase in the money supply, based on the mechanics of fractional reserve banking and the multiplier effect, is indeed