Chapter 15 – Money Creation
15-1
CHAPTER 15
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?
3. Describe “bank runs.” How can “bank runs” be avoided?
4. Why are financial institutions required to keep reserves?
5. Explain what is meant by fractional reserve banking.
6. Describe the basic features of a commercial bank’s balance sheet.
7. What are the major assets and the major claims (liabilities) on a commercial bank’s balance sheet?
8. What is the relationship between bank assets, liabilities and net worth?
9. 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)?
10. “The main purpose of required reserves is to promote bank liquidity and protect depositors.” Evaluate this
statement.
11. 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
12. 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
establish the physical location of the bank. Finally, they open the bank and receive $750,000 in checkable
deposits. With these reserves, they make $600,000 worth of loans.
13. Define the reserve ratio.
14. How does the reserve requirement change for banks and thrifts as the size of the bank changes?
15. Does the Fed pay interest on required reserves and excess reserve balances held at the Federal Reserve
bank?
16. Why are reserves listed in the assets column of a bank’s balance sheet?
17. Give an equation that shows the relationship between actual, required, and excess reserves.
18. Is the purpose of required bank reserves to enhance liquidity and protect commercial bank depositors from
losses? Explain.
19. How are bank customers protected against bank failures? Explain.
Chapter 15 – Money Creation
15-2
20. 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
21. 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
22. 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?
23. 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?
Chapter 15 – Money Creation
15-3
24. Jack deposits his money at Bank 1, while Maria deposits her money at Bank 2. Balance sheets for each
bank are listed below.
Bank 1
Assets
Liabilities + Net Worth
Reserves $200,000
Property 600,000
Loans 600,000
Checkable deposits $ 400,000
Stock shares 1,000,000
Bank 2
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?
25. 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.
26. What is the effect on the money supply when a commercial bank buys government securities from the
public?
27. What is the effect on the money supply when a commercial bank sells government securities to the public?
28. Banks pursue two conflicting goals. Explain what they are and why the conflict.
29. What are the two conflicting goals of bankers? How do these conflicting goals get resolved in the Federal
funds market?
30. How do banks partly reconcile the goals of profits and liquidity?
31. What is meant by the “Federal funds market” and what is the Federal funds rate?
32. 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?
Chapter 15 – Money Creation
15-4
33. 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?
34. 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?
35. 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
36. 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
37. Define the monetary multiplier.
38. Give an equation that shows the relationship between excess reserves, maximum checkable-deposit
expansion, and the monetary multiplier.
39. How can money be “destroyed” in the same way that checkable deposits expand the money supply?
40. (Last Word) What led to the bank runs of the early 1930s?
41. (Last Word) What effect did the bank panics of 1930–1933 have on the money supply? Explain.
Chapter 15 – Money Creation
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. Describe “bank runs.” How can “bank runs” be avoided?
4. Why are financial institutions required to keep reserves?
5. Explain what is meant by fractional reserve banking.
6. Describe the basic features of a commercial bank’s balance sheet.
7. What are the major assets and the major claims (liabilities) on a commercial bank’s balance sheet?
Chapter 15 – Money Creation
15-6
8. What is the relationship between bank assets, liabilities and net worth?
9. 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)?
10. “The main purpose of required reserves is to promote bank liquidity and protect depositors.” Evaluate this
statement.
11. 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
(a) Reserves could come from deposits or cash capital of owners.
12. 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
establish the physical location of the bank. Finally, they open the bank and receive $750,000 in checkable
deposits. With these reserves, they make $600,000 worth of loans.
Assets
Liabilities + Net Worth
Property 200,000
Stock shares 500,000
Chapter 15 – Money Creation
15-7
13. Define the reserve ratio.
14. How does the reserve requirement change for banks and thrifts as the size of the bank changes?
15. Does the Fed pay interest on required reserves and excess reserve balances held at the Federal Reserve
bank?
16. Why are reserves listed in the assets column of a bank’s balance sheet?
17. Give an equation that shows the relationship between actual, required, and excess reserves.
18. Is the purpose of required bank reserves to enhance liquidity and protect commercial bank depositors from
losses? Explain.
19. How are bank customers protected against bank failures? Explain.
Chapter 15 – Money Creation
15-8
20. 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
21. 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
22. 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?
Assets
(all figures in thousands)
Liabilities + Net Worth
Reserves $40 $45 $45
Securities 90 90 90
Checkable $200 $205 $209
Chapter 15 – Money Creation
15-9
23. 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
Reserves $50 $60 $60.0
Securities 80 80 80.0
Loans 70 70 77.5
Checkable $200 $210 $217.5
24. Jack deposits his money at Bank 1, while Maria deposits her money at Bank 2. Balance sheets for each
bank are listed below.
Bank 1
Assets
Liabilities + Net Worth
Reserves $200,000
Property 600,000
Loans 600,000
Checkable deposits $ 400,000
Stock shares 1,000,000
Bank 2
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?
Bank 1
Assets
Liabilities + Net Worth
Chapter 15 – Money Creation
15–10
Chapter 15 – Money Creation
25. 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.
26. What is the effect on the money supply when a commercial bank buys government securities from the
public?
27. What is the effect on the money supply when a commercial bank sells government securities to the public?
28. Banks pursue two conflicting goals. Explain what they are and why the conflict.
29. What are the two conflicting goals of bankers? How do these conflicting goals get resolved in the Federal
funds market?
Chapter 15 – Money Creation
15–12
30. How do banks partly reconcile the goals of profits and liquidity?
31. What is meant by the “Federal funds market” and what is the Federal funds rate?
32. 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?
33. 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?
(a) Required reserves are $300 billion .25 = $75 billion. Actual reserves are $100 billion, so excess
Chapter 15 – Money Creation
15–13
34. 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?
35. 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
36. 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
Chapter 15 – Money Creation
37. Define the monetary multiplier.
38. Give an equation that shows the relationship between excess reserves, maximum checkable-deposit
expansion, and the monetary multiplier.
39. How can money be “destroyed” in the same way that checkable deposits expand the money supply?
40. (Last Word) What led to the bank runs of the early 1930s?
41. (Last Word) What effect did the bank panics of 1930–1933 have on the money supply? Explain.