The Central Bank of a country executes an open market sale of government securities worth … — JAMB UTME

The Central Bank of a country executes an open market sale of government securities worth $\text{N}150\text{ billion}$ to the non-bank private public, who pay using cheques drawn on their commercial bank demand deposit accounts. If commercial banks operate under a mandatory cash reserve ratio of $20\%$ and hold no excess reserves, what is the immediate net change in the narrow money supply ( $M_1$ ) and the ultimate maximum potential contraction in total commercial bank deposits?

Narrow money supply ( $M_1$ ) immediately decreases by $\text{N}150\text{ billion}$ , and total bank deposits can contract by a maximum of $\text{N}750\text{ billion}$ .Answer
B
Narrow money supply ( $M_1$ ) remains unchanged because government securities are near-money, while total bank deposits contract by $\text{N}750\text{ billion}$ .
C
Narrow money supply ( $M_1$ ) immediately decreases by $\text{N}150\text{ billion}$ , and total bank deposits contract by a maximum of $\text{N}150\text{ billion}$ .
D
Narrow money supply ( $M_1$ ) immediately increases by $\text{N}150\text{ billion}$ , and total bank deposits expand by a maximum of $\text{N}750\text{ billion}$ .

Answer

Narrow money supply (

M_1

) immediately decreases by

\text{N}150\text{ billion}

, and total bank deposits can contract by a maximum of

\text{N}750\text{ billion}

The correct option identifies that an open market sale of securities removes demand deposits from commercial banks, reducing

M_1

by the transaction value of

\text{N}150\text{ billion}

. Because banks face a cash reserve ratio of

20\%

, losing

\text{N}150\text{ billion}

in cash reserves forces a cumulative deposit contraction of

\text{N}150\text{ billion} \times \frac{1}{0.20} = \text{N}750\text{ billion}

across the banking system.

Step-by-Step Solution

Determine the immediate impact on narrow money supply (

M_1

Narrow money supply (

M_1

) consists of currency in circulation outside banks plus demand deposits. When the non-bank public writes cheques worth

\text{N}150\text{ billion}

from their demand deposits to purchase securities, demand deposits decrease immediately by

\text{N}150\text{ billion}

. Thus,

M_1

decreases by

\text{N}150\text{ billion}

Government securities are financial assets (near money/capital market instruments) and are not part of narrow money (

M_1

Calculate the credit creation multiplier.

Multiplier (

k

) =

\frac{1}{\text{Required Reserve Ratio}} = \frac{1}{0.20} = 5

The fractional reserve requirement determines how many times bank deposits can expand or contract relative to primary reserve changes.

Calculate the maximum potential contraction in total commercial bank deposits.

Maximum Deposit Contraction =

\text{Initial Reserve Loss} \times k = \text{N}150\text{ billion} \times 5 = \text{N}750\text{ billion}

Commercial banks lose

\text{N}150\text{ billion}

in primary reserves to the Central Bank, triggering a multiple contraction of credit across the banking system.

Key Concept

Impact of Open Market Operations on

M_1

and Multiple Credit Contraction via Reserve Multiplier

Estimated Time:2m 0s

Question

Answer

Step-by-Step Solution

Key Concept

Common Mistakes

Topics

More questions from this topic