The money supply in Leutonia is $5 billion, and the public holds no cash. The Leutonian Central Bank decides that it wants to double the money supply. It is considering an open market operation. The required reserve ratio in the country is 10%, and banks hold no excess reserves.

a. Should the Central Bank buy or sell bonds? Explain.

When a Central Bank wants to increase the money supply, it simply purchases government bonds from the public. This works to increase the money supply because, as the buyer of the bonds, the central bank is giving out dollars to the public. The Central Bank also keeps government bonds in its portfolio and sells them when it wants to decrease the money supply. Selling decreases the money supply because the buyers of the bonds give currency to the Central Bank, which takes that cash out of the hands of the public.

b. How many dollars' worth of bonds should the Central Bank buy or sell? Show your calculations.

c. If banks do hold excess reserves, and the public does hold some cash, would the total increase or decrease in the money supply be higher or lower than the figure the Central Bank wants? Explain your answer.