CHAPTER 35
Money Creation
A. Short-Answer, Essays, and Problems
1. What is the history behind the idea of a fractional reserve banking system?
2. What are the two significant characteristics of the fractional reserve banking system?
4. Describe “bank runs.” How can “bank runs” be avoided?
5. Why are financial institutions required to keep reserves?
8. What are the major assets and the major claims (liabilities) on a commercial bank’s balance sheet?
9. What is the relationship between bank assets, liabilities and net worth?
10. What happens to the money supply when a bank accepts deposits of currency from the public and places it
in checkable deposits (or checking accounts)?
11. “The main purpose of required reserves is to promote bank liquidity and protect depositors.” Evaluate this
come into being.
13. Use the following bank transactions to develop the bank’s balance sheet. To start the bank, owners issue
$500,000 in stock to shareholders. Next, they purchase $200,000 worth of equipment and office space to
14. Define the reserve ratio.
15. How does the reserve requirement change for banks and thrifts as the size of the bank changes?
16. Does the Fed pay interest on required reserves and excess reserve balances held at the Federal Reserve
bank?
17. Why are reserves listed in the assets column of a bank’s balance sheet?
19. Is the purpose of required bank reserves to enhance liquidity and protect commercial bank depositors from
20. How are bank customers protected against bank failures? Explain.
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21. Determine whether the following balance sheet item is an Asset or Liabilities/Net Worth for a bank:
a) Loan to a business
b) Checkable Deposits
c) Reserves
d) Securities
22. Using the balance sheet below and assuming a required reserve ratio of 33%, answer the following: (a)
What is the amount of excess reserves? (b) This bank can safely expand its loans by what amount? (c) By
expanding its loans by this amount in part (b), its checkable deposits would expand to what amount (if all
loans were made to checking account customers)? (d) If checks clear against the bank equal to the amount
loaned in (b), how much would remain in reserves and in checkable deposits?
Assets
Liabilities + Net Worth
Reserves $ 60,000
Loans 60,000
Securities 40,000
Property 290,000
Checkable deposits $150,000
Stock shares 300,000
23. Using the balance sheet below and assuming a required reserve ratio of 20%, answer the following: (a)
What is the amount of excess reserves? (b) This bank can safely expand its loans by what amount? (c) By
expanding its loans by this amount in part (b), its checkable deposits would expand to what amount (if all
loans were made to checking account customers)? (d) If checks clear against the bank equal to the amount
loaned in (b), how much would remain in reserves and in checkable deposits?
Assets
Liabilities + Net Worth
Reserves $ 40,000
Loans 70,000
Securities 50,000
Property 400,000
Checkable deposits $100,000
Stock shares 460,000
24. Suppose the First National Bank has the following simplified balance sheet. The reserve ratio is 20%.
Assets
(all figures in thousands)
Liabilities + Net Worth
(1) (2)
Reserves $40 _____ _____
Securities 90 _____ _____
Loans 70 _____ _____
(1) (2)
Checkable $200 _____ _____
deposits
Assume that households and businesses deposit $5000 in this bank and that this currency is added to the
bank’s reserves.
In column (1) show the bank’s balance sheet after this occurs. Is there a change in the money supply?
In column (2) show what would happen if the bank now loans all of its excess reserves to a depositor. Is
there a change in the money supply?
25. Suppose the Second National Bank has the following simplified balance sheet. The reserve ratio is 25%.
Assets
(all figures in thousands)
Liabilities + Net Worth
(1) (2)
Reserves $50 _____ _____
Securities 80 _____ _____
Loans 70 _____ _____
(1) (2)
Checkable $200 _____ _____
deposits
Assume that households and businesses deposit $10,000 in this bank and that this currency is added to the
bank’s reserves.
In column (1) show the bank’s balance sheet after this occurs. Is there a change in the money supply?
In column (2) show what would happen if the bank now loans all of its excess reserves to a depositor. Is
there a change in the money supply?
26. Jack deposits his money at Bank 1, while Maria deposits her money at Bank 2. Balance sheets for each
bank are listed below.
Assets
Liabilities + Net Worth
Reserves $200,000
Property 600,000
Loans 600,000
Checkable deposits $ 400,000
Stock shares 1,000,000
Assets
Liabilities + Net Worth
Reserves $150,000
Property 250,000
Loans 600,000
Checkable deposits $300,000
Stock shares 700,000
(a) What will the banks’ balance sheets look like when Jack writes a $50,000 check to Maria and the
check clears?
(b) The reserve ratio is 20%. What are each bank’s excess reserves after the check clears in (a)?
(c) How many additional loans can each bank make when Jack writes Maria another check for $100,000?
27. When a check is drawn against bank A and deposited in another bank, the first bank loses reserves as the
check is cleared. Yet the check collection involves no loss of reserves by the banking system. Explain
28. What is the effect on the money supply when a commercial bank buys government securities from the
public?
29. What is the effect on the money supply when a commercial bank sells government securities to the public?
30. For each of the situations below determine whether the money supply will increase, decrease, or stay the
same.
31. Banks pursue two conflicting goals. Explain what they are and why the conflict.
32. What are the two conflicting goals of bankers? How do these conflicting goals get resolved in the Federal
funds market?
33. How do banks partly reconcile the goals of profits and liquidity?
34. What is meant by the “Federal funds market” and what is the Federal funds rate?
36. Answer the next questions based on the following consolidated balance sheet for the commercial banking
system. Assume the required reserve ratio is 30%. All figures are in millions of dollars.
Assets
Liabilities + Net Worth
Reserves $200
Securities 500
Loans 100
Property 500
Checkable deposits $600
Stock shares 700
37. Answer the next questions based on the following consolidated balance sheet for the commercial banking
system. Assume the required reserve ratio is 25%. All figures are in billions of dollars.
Assets
Liabilities + Net Worth
Reserves $100
Securities 200
Loans 100
Property 600
Checkable deposits $300
Stock shares 700
38. Answer the next questions based on the following consolidated balance sheet for the commercial banking
system. Assume the required reserve ratio is 20%. All figures are in billions of dollars.
Assets
Liabilities + Net Worth
Reserves $ 60
Securities 140
Loans 100
Property 400
Checkable deposits $200
Stock shares 500
39. If the balance sheet below were for the entire banking system instead of just a single bank, by how much
could loans be expanded? Assume a reserve ratio of 33%.
Assets
Liabilities + Net Worth
Reserves $ 60,000
Securities 60,000
Loans 40,000
Property 290,000
Checkable deposits $150,000
Stock shares 300,000
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40. If the balance sheet below were for the entire banking system instead of just a single bank, by how much
could loans be expanded? Assume a reserve ratio of 20%.
Assets
Liabilities + Net Worth
Reserves $ 40,000
Securities 70,000
Loans 50,000
Property 400,000
Checkable deposits $100,000
Stock shares 460,000
41. Define the monetary multiplier.
42. Give an equation that shows the relationship between excess reserves, maximum checkable-deposit
43. How can money be “destroyed” in the same way that checkable deposits expand the money supply?
44. (Last Word) Suppose John makes a $250 investment, he uses $50 of his own savings and borrows $200
(borrowing at zero percent interest from his mom). Use this information to answer the following questions.
45. (Last Word) Suppose Susan makes a $100 investment, she uses $10 of her own savings and borrows $90
(borrowing at zero percent interest from her mom). Use this information to answer the following questions.
46. (Last Word) Discuss the effect leverage has on a bank’s profit.
B. Answers to Short-Answer, Essays, and Problems
1. What is the history behind the idea of a fractional reserve banking system?
2. What are the two significant characteristics of the fractional reserve banking system?
3. Explain what bank reserves are and the ways that banks can hold them.
4. Describe “bank runs.” How can “bank runs” be avoided?
5. Why are financial institutions required to keep reserves?
6. Explain what is meant by fractional reserve banking.
7. Describe the basic features of a commercial bank’s balance sheet.
On the left side of the balance sheet of a commercial bank is a statement of the bank’s assets. On the right
side of the balance sheet are the claims of the owners of the bank, called net worth, and claims of the
nonowners, called liabilities. This relationship would be written in equation form as: assets = liabilities +
net worth.
8. What are the major assets and the major claims (liabilities) on a commercial bank’s balance sheet?
9. What is the relationship between bank assets, liabilities and net worth?
10. What happens to the money supply when a bank accepts deposits of currency from the public and places it
in checkable deposits (or checking accounts)?
11. “The main purpose of required reserves is to promote bank liquidity and protect depositors.” Evaluate this
statement.
12. Arrange the following items in the form of a commercial bank’s balance sheet, and explain how each might
come into being.
Stock shares, $300,000; Reserves, $60,000; Property, $290,000; Checkable deposits, $150,000; Securities,
$40,000; Loans, $60,000
Assets
Liabilities + Net Worth
Reserves $ 60,000
Loans 60,000
Securities 40,000
Property 290,000
Checkable deposits $150,000
Stock shares 300,000
13. Use the following bank transactions to develop the bank’s balance sheet. To start the bank, owners issue
$500,000 in stock to shareholders. Next, they purchase $200,000 worth of equipment and office space to
14. Define the reserve ratio.
The required reserve ratio is the fraction or percentage of reserves which must be held against deposits by
15. How does the reserve requirement change for banks and thrifts as the size of the bank changes?
16. Does the Fed pay interest on required reserves and excess reserve balances held at the Federal Reserve
Bank?
17. Why are reserves listed in the assets column of a bank’s balance sheet?
18. Give an equation that shows the relationship between actual, required, and excess reserves.
Actual reserves = required plus excess reserves; or alternatively, excess reserves = actual minus required
19. Is the purpose of required bank reserves to enhance liquidity and protect commercial bank depositors from
losses? Explain.
20. How are bank customers protected against bank failures? Explain.
Bank deposits are protected through periodic examinations of banks by regulatory agencies. In addition,
insurance is provided through such institutions as the Federal Deposit Insurance Corporation (FDIC). It
provides protection for individuals for a loss of up to $250,000. A similar insurance program is provided
21. Determine whether the following balance sheet item is an Asset or Liabilities/Net Worth for a bank:
22. Using the balance sheet below and assuming a required reserve ratio of 33%, answer the following: (a)
What is the amount of excess reserves? (b) This bank can safely expand its loans by what amount? (c) By
expanding its loans by this amount in part (b), its checkable deposits would expand to what amount (if all
loans were made to checking account customers)? (d) If checks clear against the bank equal to the amount
loaned in (b), how much would remain in reserves and in checkable deposits?
Assets
Liabilities + Net Worth
Reserves $ 60,000
Loans 60,000
Securities 40,000
Property 290,000
Checkable deposits $150,000
Stock shares 300,000
Reserves $ 40,000
Loans 70,000
Securities 50,000
Property 400,000
Checkable deposits $100,000
Stock shares 460,000
Securities 90 _____ _____
Reserves $40 $45 $45
Securities 90 90 90
Checkable $200 $205 $209
25. Suppose the Second National Bank has the following simplified balance sheet. The reserve ratio is 25%.
Assets
(all figures in thousands)
Liabilities + Net Worth
(1) (2)
Reserves $50 _____ _____
Securities 80 _____ _____
Loans 70 _____ _____
(1) (2)
Checkable $200 _____ _____
deposits
Assume that households and businesses deposit $10,000 in this bank and that this currency is added to the
bank’s reserves.
In column (1) show the bank’s balance sheet after this occurs. Is there a change in the money supply?
In column (2) show what would happen if the bank now loans all of its excess reserves to a depositor. Is
there a change in the money supply?
Assets
(all figures in thousands)
Liabilities + Net Worth
(1) (2)
Reserves $50 $60 $60.0
Securities 80 80 80.0
Loans 70 70 77.5
(1) (2)
Checkable $200 $210 $217.5
deposits
No, currency has been reduced dollar-for-dollar with the $10,000 increase in checkable deposits.
Yes, the $7500 excess reserves increase checkable deposit money by $7500.
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26. Jack deposits his money at Bank 1, while Maria deposits her money at Bank 2. Balance sheets for each
bank are listed below.
Assets
Liabilities + Net Worth
Reserves $200,000
Property 600,000
Loans 600,000
Checkable deposits $ 400,000
Stock shares 1,000,000
Assets
Liabilities + Net Worth
Reserves $150,000
Property 250,000
Loans 600,000
Checkable deposits $300,000
Stock shares 700,000
(a) What will the banks’ balance sheets look like when Jack writes a $50,000 check to Maria and the
check clears?
(b) The reserve ratio is 20%. What are each bank’s excess reserves after the check clears in (a)?
(c) How many additional loans can each bank make when Jack writes Maria another check for $100,000?
Assets
Liabilities + Net Worth
Reserves $150,000
Property 600,000
Loans 600,000
Checkable deposits $ 350,000
Stock shares 1,000,000
Assets
Liabilities + Net Worth
Reserves $200,000
Property 250,000
Loans 600,000
Checkable deposits $350,000
Stock shares 700,000
27. When a check is drawn against bank A and deposited in another bank, the first bank loses reserves as the
check is cleared. Yet the check collection involves no loss of reserves by the banking system. Explain
what significance this has for the lending ability of the system as a whole.
The system does not lose reserves as long as checks are being redeposited in other banks. The reserves
28. What is the effect on the money supply when a commercial bank buys government securities from the
public?
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of McGraw-Hill Education.
The effect is the same as bank lending. The bank buying the securities issues a check that in turn gets
deposited in a bank. The checkable deposits of that bank have increased its lending ability by increasing its
excess reserves.
29. What is the effect on the money supply when a commercial bank sells government securities to the public?
30. For each of the situations below determine whether the money supply will increase, decrease, or stay the
same.
(a) An individual deposits $100 of cash into a savings account.
(b) The bank makes a $10,000 loan to an individual for the purchase of a used car.
(c) A commercial bank sells government bonds to the public.
31. Banks pursue two conflicting goals. Explain what they are and why the conflict.
32. What are the two conflicting goals of bankers? How do these conflicting goals get resolved in the Federal
funds market?
33. How do banks partly reconcile the goals of profits and liquidity?
34. What is meant by the “Federal funds market” and what is the Federal funds rate?
35. Examine the actions taken by the Federal Reserve during the recession and how the Federal Funds Market
has changed since the crisis.
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Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
During the financial crisis the Federal Reserve wanted to increase the amount of excess reserves available
to banks in order for them to make more loans. To do this the Federal Reserve purchased a significant
amount of bank owned assets, paying the banks with reserves. The increase in excess reserves on banks
balances sheets means they did not need to borrow reserves from other banks. The vast amount of excess
reserves in the banking sector reduced the need for the Federal Funds Market.
36. Answer the next questions based on the following consolidated balance sheet for the commercial banking
system. Assume the required reserve ratio is 30%. All figures are in millions of dollars.
Assets
Liabilities + Net Worth
Reserves $200
Securities 500
Loans 100
Property 500
Checkable deposits $600
Stock shares 700
(a) What is the amount of excess reserves in this commercial banking system?
(b) What is the maximum amount that the money supply can be expanded?
(c) If the reserve ratio fell to 25%, what is now the maximum amount that the money supply can be
expanded?
37. Answer the next questions based on the following consolidated balance sheet for the commercial banking
system. Assume the required reserve ratio is 25%. All figures are in billions of dollars.
Assets
Liabilities + Net Worth
Reserves $100
Securities 200
Loans 100
Property 600
Checkable deposits $300
Stock shares 700
(a) What is the amount of excess reserves in this commercial banking system?
(b) What is the maximum amount that the money supply can be expanded?
(c) If the reserve ratio fell to 25%, what is now the maximum amount that the money supply can be
expanded?
38. Answer the next questions based on the following consolidated balance sheet for the commercial banking
system. Assume the required reserve ratio is 20%. All figures are in billions of dollars.
Assets
Liabilities + Net Worth
Reserves $ 60
Securities 140
Loans 100
Property 400
Checkable deposits $200
Stock shares 500
(a) What is the amount of excess reserves in this commercial banking system?
(b) What is the maximum amount that the money supply can be expanded?
(c) If the reserve ratio fell to 10%, what is now the maximum amount that the money supply can be
expanded?
39. If the balance sheet below were for the entire banking system instead of just a single bank, by how much
could loans be expanded? Assume a reserve ratio of 33%.
Assets
Liabilities + Net Worth
Reserves $ 60,000
Securities 60,000
Loans 40,000
Property 290,000
Checkable deposits $150,000
Stock shares 300,000
40. If the balance sheet below were for the entire banking system instead of just a single bank, by how much
could loans be expanded? Assume a reserve ratio of 20%.
Assets
Liabilities + Net Worth
Reserves $ 40,000
Securities 70,000
Loans 50,000
Property 400,000
Checkable deposits $100,000
Stock shares 460,000
41. Define the monetary multiplier.
42. Give an equation that shows the relationship between excess reserves, maximum checkable-deposit
expansion, and the monetary multiplier.
43. How can money be “destroyed” in the same way that checkable deposits expand the money supply?
44. (Last Word) Suppose John makes a $250 investment, he uses $50 of his own savings and borrows $200
(borrowing at zero percent interest from his mom). Use this information to answer the following questions.
45. (Last Word) Suppose Susan makes a $100 investment, she uses $10 of her own savings and borrows $90
(borrowing at zero percent interest from her mom). Use this information to answer the following questions.
(a) Suppose the investment earns her $125, what is her return?
(b) How would the return change if Susan funded the investment by only her savings?
46. (Last Word) Discuss the effect leverage has on a bank’s profit.