The Impact of Fed Reserves Injection on Monetary Base and Money Supply

What happens when the Fed injects reserves into the banking system and they are held as excess reserves?

1) remains unchanged; remains unchanged 2) remains unchanged; increases 3) increases; increases 4) increases; remains unchanged

Answer:

The Federal Reserve injecting reserves into the banking system increases the monetary base, but if banks hold these extra funds as excess reserves instead of lending them out, the overall money supply remains unchanged.

The correct answer to the given question is option 4: increases; remains unchanged. When the Federal Reserve injects reserves into the banking system, it leads to an increase in the monetary base, which is the total amount of money in circulation in the economy. However, if banks decide to keep these additional reserves as excess reserves, the money supply, which represents the total amount of money available for spending in the economy, does not increase.

This scenario occurs because when banks choose to hoard the injected reserves as excess reserves rather than lending them out, the circulation of money in the economy remains constant. As a result, even though the monetary base expands due to the Fed's injection of reserves, the money supply does not experience any growth.

Understanding the relationship between the injection of reserves, the monetary base, and the money supply is crucial for grasping the dynamics of monetary policy and its impact on the broader economy. By monitoring how banks utilize injected reserves, policymakers can assess the effectiveness of their strategies in influencing economic activity and maintaining financial stability.