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Banking & Fractional Reserve - High School Economics

  1. The First Bank of Econland is 'fully loaned up,' meaning it holds no excess reserves. Its checkable deposits are $2,000,000 and its total reserves are $250,000. Based on this information, what is the required reserve ratio?
    Answer: 12.5% If the bank is fully loaned up, its total reserves are equal to its required reserves. The required reserve ratio is calculated as Required Reserves / Checkable Deposits. Therefore, the ratio is $250,000 / $2,000,000 = 0.125, or 12.5%.
  2. Suppose the reserve requirement is 20%. A customer withdraws $10,000 from a checking account and holds it as currency. If all banks in the system were previously 'fully loaned up', what is the maximum potential contraction of the M1 money supply resulting from this action?
    Answer: $40,000 The banking system loses $10,000 in deposits and $10,000 in reserves. This initiates a reverse multiplier effect. The total decrease in checkable deposits will be $10,000 × (1/0.20) = $50,000. However, the M1 money supply includes both checkable deposits and currency in circulation. Deposits decrease by $50,000, but currency held by the public increases by the $10,000 that was withdrawn. The net change in M1 is a decrease of $40,000 (–$50,000 + $10,000).
  3. The fundamental assumption that allows the fractional reserve banking system to function is that:
    Answer: not all depositors will demand to withdraw their funds at the same time. The entire system is built on the premise that only a fraction of deposits will be withdrawn on any given day. This allows banks to safely lend out the rest of the deposited funds. While the other statements are related to banking, they are not the core assumption underpinning the existence of fractional reserve banking itself.
  4. In modern economies, the primary purpose of setting a required reserve ratio is to:
    Answer: influence the money supply as a tool of monetary policy. While reserve requirements were historically related to ensuring liquidity, their primary function in a modern economy is as a tool for the central bank to control the money supply. By changing the ratio, the central bank can alter the money multiplier and influence the amount of money commercial banks can create through lending. It cannot ensure solvency against a bank run (A) and is not primarily for limiting profits (B) or funding the government (C).
  5. When a borrower repays the principal of a $5,000 loan to a bank using funds from a checking account at that same bank, what is the immediate effect on the bank's balance sheet?
    Answer: The bank's total assets and total liabilities both decrease by $5,000. The loan is an asset to the bank. The checking deposit is a liability. When the borrower repays the loan from their account, the bank's 'Loans' asset account decreases by $5,000. Simultaneously, the bank's 'Checkable Deposits' liability account decreases by $5,000. This action causes both sides of the balance sheet (assets and liabilities) to shrink.
  6. The money multiplier effect might not reach its theoretical maximum. Which of the following represents a decision by the public (non-bank individuals or firms) that would limit the money creation process?
    Answer: Choosing to hold more funds in currency rather than depositing them in banks. The money multiplier assumes that all loan proceeds are redeposited into the banking system. If the public chooses to hold some of these funds as cash (a 'currency drain'), that money leaks out of the fractional reserve process, and the multiplier effect is reduced. Distractor C is a decision by banks, not the public. Distractor D is an action by the central bank. Distractor B does not, by itself, reduce the money supply, as the withdrawn money is typically spent and redeposited.
  7. A banking system has $1 trillion in deposits. The central bank lowers the required reserve ratio from 20% to 15%. This action, by itself, immediately gives commercial banks:
    Answer: an additional $50 billion in excess reserves. Initially, required reserves were 20% of $1 trillion, which is $200 billion. After the change, required reserves are 15% of $1 trillion, which is $150 billion. The amount of total reserves in the system has not changed, but the amount that is required has dropped by $50 billion ($200B - $150B). This $50 billion is reclassified from required reserves to excess reserves, making it available for new lending.
  8. A customer deposits $10,000 in cash into a checking account at a bank. If the required reserve ratio is 20%, what is the maximum amount of new loans the entire banking system can create as a result of this single deposit?
    Answer: $40,000 First, the initial bank must hold 20% of the $10,000 deposit as required reserves ($2,000). It can lend out the remaining excess reserves of $8,000. This initial loan, when deposited and re-lent throughout the banking system, is subject to the money multiplier, which is 1/0.20 = 5. The total amount of new loans created by the system is the initial excess reserves multiplied by the money multiplier: $8,000 × 5 = $40,000. Distractor A is only the first loan. Distractor D represents the total increase in deposits, not new loans.
  9. A commercial bank has checkable deposits of $500,000 and total reserves of $80,000. The required reserve ratio is 12%. A customer then withdraws $10,000 in cash. Immediately after this withdrawal, what are the bank's excess reserves?
    Answer: $11,200 Initially, required reserves are 0.12 $500,000 = $60,000. Initial excess reserves are $80,000 - $60,000 = $20,000. After the withdrawal, deposits become $490,000 and total reserves become $70,000. The new required reserves are 0.12 $490,000 = $58,800. The new excess reserves are the new total reserves minus the new required reserves: $70,000 - $58,800 = $11,200. Distractor A incorrectly subtracts the full withdrawal amount from the initial excess reserves. Distractor C subtracts the change in required reserves from the initial excess reserves. Distractor D is the initial amount of excess reserves.
  10. A central bank's open market sale of $5 million in government securities to the public will, assuming a reserve ratio of 10% and that all money is redeposited in the banking system, lead to a maximum potential:
    Answer: decrease in the money supply of $50 million. When the public buys securities from the central bank, they pay with checks drawn on their commercial bank accounts. This drains reserves from the banking system. A loss of $5 million in reserves will trigger a multiple contraction of the money supply. The maximum change is calculated as the initial change in reserves times the money multiplier: –$5,000,000 × (1/0.10) = –$50,000,000.
  11. A bank's balance sheet shows the following: Total Reserves: $60,000; Government Securities: $140,000; Loans: $300,000. Its only liability is checkable deposits. If the required reserve ratio is 10%, this bank is currently able to extend new loans up to a maximum of:
    Answer: $10,000 First, determine the bank's total checkable deposits. Assets must equal liabilities. Total assets are Reserves ($60k) + Securities ($140k) + Loans ($300k) = $500,000. Therefore, checkable deposits must be $500,000. Required reserves are 10% of deposits, so $500,000 × 0.10 = $50,000. The bank has $60,000 in total reserves, so its excess reserves are $60,000 - $50,000 = $10,000. A bank can lend out its excess reserves.
  12. A commercial bank is currently meeting its reserve requirement exactly and has no excess reserves. The central bank then conducts an open market purchase of securities from this bank. The immediate effect of this transaction is that the commercial bank now has:
    Answer: fewer securities and more excess reserves. When the central bank purchases securities from the commercial bank, it pays for them by crediting the bank's reserve account. This means the bank's securities holdings (an asset) decrease, and its total reserves (another asset) increase. Because the bank's deposits have not changed, its required reserves are unchanged. Therefore, the entire increase in total reserves becomes excess reserves, which can be used for new lending.
  13. Which statement most accurately describes the process of money creation in a fractional reserve banking system?
    Answer: Banks create money when they use excess reserves to make loans, which become new deposits in the banking system. Money creation occurs not from printing currency (distractor A) or simply holding deposits (distractor B), but through the act of lending. When a bank makes a loan, it creates a new checkable deposit for the borrower. This new deposit is 'new' money (part of M1). This process is fueled by the bank's excess reserves. Distractor D describes intermediation, but not the creation of new money.
  14. When a bank with excess reserves originates a new $20,000 auto loan, it typically credits the borrower's checking account with $20,000. What is the immediate result of this single transaction on the bank's balance sheet?
    Answer: Assets in the form of loans increase, and liabilities in the form of deposits increase. The creation of a loan is an accounting entry. The bank acquires a new asset, the borrower's IOU ('Loans'), valued at $20,000. Simultaneously, it creates a new liability for itself, the 'Checkable Deposit' for the borrower, also for $20,000. Both sides of the balance sheet increase by $20,000. Distractor D describes what happens later, when the borrower spends the money and the funds are transferred to another bank.
  15. Consider a deposit of $1,000. In which scenario is the potential for M1 money supply expansion the greatest, assuming a 10% reserve requirement?
    Answer: Scenario B: The central bank buys a $1,000 bond from an individual, who then deposits the proceeds. In Scenario A, the initial deposit is a conversion of existing money (currency to deposit), so M1 is initially unchanged. The bank can lend $900, leading to a maximum new money creation of $9,000 ($900 x 10). In Scenario B, the central bank's purchase creates $1,000 of new reserves and a new $1,000 deposit, increasing M1 by $1,000 immediately. The bank can then lend $900, creating an additional $9,000. The total expansion in Scenario B is $1,000 + $9,000 = $10,000, which is greater than in Scenario A.
  16. A depositor moves $2,000 from a personal savings account to a personal checking account at the same bank. Assume the reserve requirement is 10% on checking deposits and 0% on savings deposits. What is the immediate impact of this transfer on the bank's required reserves and its ability to create new loans?
    Answer: Required reserves increase by $200, and its lending ability decreases. The bank's total reserves do not change because this is an internal transfer of funds. However, the composition of its liabilities changes. The $2,000 is now in a checking account, which has a 10% reserve requirement. Required reserves increase by $2,000 × 0.10 = $200. Since total reserves are constant and required reserves have increased, the bank's excess reserves (the funds available for new loans) must decrease by $200.
  17. With a 10% reserve requirement, Amy deposits $500 of currency into Bank A. Bank A makes the maximum possible loan to Ben, who buys a product from Chloe. Chloe deposits the entire payment into Bank B. Bank B then makes the maximum possible loan to David. What is the amount of David's loan?
    Answer: $405.00 1. Bank A receives a $500 deposit. It must reserve 10% ($50) and can lend out the remaining $450. This is the loan to Ben. 2. Ben pays Chloe $450, and she deposits this into Bank B. 3. Bank B now has a new deposit of $450. It must reserve 10% of this ($45) and can lend out the remaining $405. This is the loan to David.
  18. On a commercial bank's balance sheet, which of the following are both classified as assets?
    Answer: Reserves and loans Assets represent what the bank owns or is owed. Reserves (cash in the vault or at the central bank) and loans made to customers are both assets. Liabilities represent what the bank owes to others. Checkable deposits are liabilities because the bank owes that money to depositors. Owner's equity is also on the liability/equity side of the balance sheet.
  19. If an initial injection of $5,000 in new excess reserves into the banking system leads to a total potential increase of $25,000 in new loans, what must the required reserve ratio be?
    Answer: 20% The formula for the total potential increase in loans is: Change in Loans = Initial Change in Excess Reserves × Money Multiplier. The money multiplier is 1/RR. So, $25,000 = $5,000 × (1/RR). Dividing both sides by $5,000 gives 5 = 1/RR. Solving for RR gives RR = 1/5, or 20%.
  20. If the public decides to hold less currency and deposit more of their money into checking accounts, what is the likely impact on the banking system's ability to create money, assuming banks lend out all excess reserves?
    Answer: It will increase the ability to create money because banks will have more reserves to support lending. When the public holds less currency and more deposits, the commercial banking system gains reserves. Currency held by the public is outside the banking system's control, but when it is deposited, it becomes part of the reserves that can be multiplied through the fractional reserve lending process. More reserves mean more excess reserves, which directly increases the banking system's capacity to create new loans and money.

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