Suppose that the reserve requirement for checking deposits is 16 percent and that banks do not hold any excess reserves. If the Fed sells $2 million of government bonds, the economy's reserves by $ million, and the money supply will by $ million.

Decreases by $2 million; Money supply decreases by $12.5 million

Explanation:

Given that,

Required reserve ratio = 16 percent

Government bonds sold by Fed = $2 million

Therefore, the economy's reserve decreases by:

= Change in money supply * Required reserve ratio

= $12.5 million * 0.16

= $2 million.

Money multiplier = 1 : Required reserve ratio

= 1 : 0.16

= 6.25

Money supply decreases by:

= Money multiplier * Decline in reserves

= 6.25 * $2 million

= $12.5 million