Assume that the reserve requirement is 5 percent. All other things being equal, will the money supply expand more if the Fed buys \(2,000\) worth of bonds or if someone deposits in a bank \(2,000\) that she had been hiding in her cookie jar? If one of these actions creates more money than the other, how much more does it create? Support your thinking.

The reserve requirement is a fundamental concept in banking regulation, dictating the portion of depositors' balances that banks must keep on hand as cash. This serves multiple purposes including ensuring that banks have enough funds to meet day-to-day withdrawal demands, and as a monetary policy tool to regulate the amount of money in circulation.

For example, with a 5% reserve requirement, a bank is required to keep 5 cents for every dollar deposited, while the remaining 95 cents can be used to extend loans. The decision to change the reserve requirement can have broad implications on the banking sector's capability to create new loans and, thereby, affect the money supply in the economy. If the reserve requirement is decreased, banks can loan more money, potentially leading to a larger increase in the money supply.

Related closely to the reserve requirement is the concept of the money multiplier. The money multiplier refers to the maximum amount the money supply could increase based on an initial deposit. It is determined by the formula:\[ \text{Money Multiplier} = \frac{1}{\text{Reserve Requirement Ratio}} \]

In a situation where the reserve requirement is 5%, the money multiplier would be 20, which implies that every dollar deposited in the banking system has the potential to increase the total money supply by up to twenty dollars. This multiplication effect stems from the process of banks making loans from deposited funds, which are then redeposited, creating a cycle of money creation.

Banks are required to hold a certain percentage of their depositors' money in reserves. These banking system reserves serve as a safety net and are not used for lending. Reserves may be held as cash in the bank's vault or as deposits at the Federal Reserve.

Changes to these reserves can influence the bank’s ability to make loans. When there is an influx in reserves, such as through a deposit or Federal Reserve actions, banks have more ability to extend new loans, thus potentially expanding the money supply. Reserve levels are a critical component that central banks monitor and manipulate to implement monetary policy and control economic stability.

One of the key tools the Federal Reserve uses to manage the economy's money supply is through the purchasing of government bonds. When the Federal Reserve buys bonds, it effectively injects liquidity directly into the banking system, as these purchases increase the reserves banks have available to loan out.

This action is similar to depositing money into the banking system, as it can stimulate lending and, through the money multiplier effect, can result in a significant expansion of the overall money supply. As banks leverage these increased reserves to issue more loans, it can lead to economic expansion but may also raise concerns about inflation if the money supply expands too rapidly.