6.1.6 Practice_ Apply Concepts of Banking and Money Creation

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AP Macroeconomics Page 1 of 2 Assignment: Apply Concepts of Banking and Money Creation 1. The centerpiece of the U.S. economy is its banking system. A. Banks in the U.S. practice fractional reserve banking. Explain what this means. (4 points) The U.S. banking system is a fractional reserve system where banks hold a fraction of their deposits on hand, and loan the rest out. The fractional amount is set by the Federal Reserve. Fractional reserve banking is effective as long as people have faith in their banks and loans are repaid. B. Explain how banks create money under a fractional reserve system. (5 points) Banks create money because in a fractional reserve banking system, banks hold a fraction of their total deposits on hand, and loan the remainder out. By charging more interest for its loans than it pays to its depositors, the bank makes a profit. Banks typically hold some portion of their deposits in reserve and lend out the rest. C. List the two major assets and the main liability of a typical bank operating under a fractional reserve system. (3 points) Two major assets of a typical bank operating under a fractional reserve system are loans to the public and deposits at the Fed. The main liability of a typical bank are customer deposits at the bank D. Fractional reserve banking is effective as long as two things remain true. What are those two things, and why does fractional reserve banking depend on them? (4 points) Fractional reserve banking is effective as long as people have faith in their banks and loans are repaid. When people lose that faith, the bank can experience a run. A run on a bank is when many depositors show up all at once and demand their balance in cash. The bank doesn't have the funds on hand to pay everyone and often finds itself out of business. 2. The Fed plays a number of important roles in the U.S. economy. Among the things it does is conduct research on the nation's economy and regulate banks.

A. The Fed also acts as a bank for banks. What are the three activities the Fed undertakes when it acts as a bank for banks? Hint: What are the activities the Fed does for banks that are similar to the activities a bank does for its customers? (3 points) One activity that the Fed undertakes when it acts as a bank for banks is that banks can hold deposits at the Fed, and banks can borrow money from it. Another is that the Fed clears checks between banks. The third activity is that the Fed can also issue currency and coins. B. The Fed also controls the money supply. List and explain the three tools the Fed uses to control the money supply. (6 points) One of the tools the Fed uses to control the money supply is the required reserve ratio and it is changed only rarely. It is a stable required reserve ratio that helps to maintain a stable banking system. Another is the discount rate, which is the interest rate the Fed charges to banks for discount window loans. This loan is an overnight loan a bank takes if it needs extra funds to meet its required reserves at the end of the day. The third is the open market operations, which are sales and purchases of treasury bonds by the Fed. This tool is used constantly and continuously, with the Fed engaging in high volumes of T-bond transactions every day. 3. In exchange for his many years of hard work and devotion, National Corp Inc. gives Dave $100,000 in T-bonds. Dave sells these bonds to the Fed, and the Fed deposits the money in Dave's bank account. A. By how much does the money supply change as a result of this deposit into Dave's account from the Fed? Explain. (3 points) 100,000 (0.1) = $10,000 100,000 - 10,000 = $90,000 in excess reserves money multiplier = 10 90,000 (10) = $900,000 As a result of this deposit into Dave's account from the Fed, the money supply changed by $900,000 because reserve ratio is 10%, and Dave's deposit created $90,000 in excess reserves. B. A bank's actual reserve ratio is the percentage of total deposits a bank actually holds on to. It is made up of the percentage they are required to hold on to, known as the required reserve ratio, plus any extra they choose to hold on to. Suppose Dave's bank has an actual reserve ratio of 12%, and his bank makes a loan to Darlene based on the funds from Dave's deposit. How much does the money supply increase as a result of this second step? (3 points) 100,000/0.12 = $833,333.33 Money supply will increase by $833,333.33

C. Darlene uses the money to buy a very expensive pair of soccer cleats from Arthur. Arthur deposits this money in his bank account. His bank holds onto 12% of the deposit and lends the rest out. How much does the money supply increase as a result of this step? (4 points) $833,333.33/0.12 = $6,944,444.44 Money supply will increase by $6,944,444.44 D. In total, by what amount does the original $100,000 that the Fed released into circulation end up increasing the money supply if every bank holds 12% of its deposits? (4 points) If ARR is 12%, the maximum change in money would be 100,000/0.12, which is $833,333. _____________ Copyright © 2021 Apex Learning. See Terms of Use for further information. AP Macroeconomics Page 2 of 2 Assignment: Apply Concepts of Banking and Money Creation E. This example shows the increase in the money supply caused by an increase in bank deposits. Explain why this activity by banks is called money creation. (5 points) This activity by banks is called money creation because by loaning out a percentage of their deposits, THere is an increase in money supply. The deposits are counted as part of the money supply, but the loans create new deposits, which are also part of the money supply. 4. If a bank becomes worried about the future, it may decide to increase the level of excess reserves it holds in hopes of avoiding a trip to the Fed's discount window. A. If a large number of banks increase their excess reserve ratio, or the share of total deposits held in excess reserve, what effect will this have on the money supply? Explain your answer. (4 points) If a large number of banks increase their excess reserve ratio or the share of total deposits held in excess reserve, then it will cause a decrease in the money supply since the number of loans made decreases and there isn't as much money put into circulation. B. If a large number of banks decrease their excess reserve ratio, what effect will this have on the money supply? Explain your answer. (4 points) If a large number of banks decrease their excess reserve ratio, then there will be an increase in money supply, since there will be more loaning going on, and more money will be put into circulation.

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5. Explain why bank runs are a particularly important problem under fractional reserve systems and the role that the FDIC plays in preventing them. (8 points) Bank runs are a particularly important problem under fractional reserve systems because the U.S. banking system is a fractional reserve system, and fractional reserve banking is effective as long as people have faith in their banks and loans are repaid. When people lose that faith, the bank can experience a run on a bank, where many depositors show up all at once and demand their balance in cash. The bank doesn't have the funds on hand to pay everyone and often finds itself out of business. The FDIC, which is a federal insurance program on bank deposits, will help prevent bank runs: IIf one deposits money at an FDIC-insured bank and the bank fails, the government promises to give them their deposit up to $100,000. _____________ Copyright © 2021 Apex Learning. See Terms of Use for further information.

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