Chapter 15 – Money Creation
Chapter 15 – Money Creation
McConnell Brue Flynn 20e
DISCUSSION QUESTIONS
1. Explain why merchants accepted gold receipts as a means of payment even though the receipts
were issued by goldsmiths, not the government. What risk did goldsmiths introduce into the
payments system by issuing loans in the form of gold receipts? LO1
Answer: When early traders began to use gold in making transactions, they soon realized
that it was both unsafe and inconvenient to carry gold and to have it weighed and assayed
(judged for purity) every time they negotiated a transaction. So by the sixteenth century
The potential problem was that if the goldsmith issued more receipts than he had in gold
the goldsmith was vulnerable to “panics” or “runs.” For example, if a goldsmith issued
2. Why is the banking system in the United States referred to as a fractional reserve bank system?
What is the role of deposit insurance in a fractional reserve system? LO1
Answer: The banking system in the United States is a fractional reserve bank system
because the banks do not hold enough cash or reserves on hand to pay every depositor on
To avoid the potential of these bank runs there is deposit insurance in the United States
3. What is the difference between an asset and a liability on a bank’s balance sheet? How does net
worth relate to each? Why must a balance sheet always balance? What are the major assets and
claims on a commercial bank’s balance sheet? LO2
Answer: An asset of a commercial bank is something owned by the bank or owed to the
bank (cash, securities, loans, etc…). A liability of the bank is a claim against the bank by
The major assets of a bank are reserves, securities, loans, and vault cash (this last one is
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Chapter 15 – Money Creation
4. Why does the Federal Reserve require commercial banks to have reserves? Explain why
reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are
excess reserves? How do you calculate the amount of excess reserves held by a bank? What is the
significance of excess reserves? LO2
Answer: Reserves provide the Fed a means of controlling the money supply. It is
Reserves are assets of commercial banks because these funds are cash belonging
5. “Whenever currency is deposited in a commercial bank, cash goes out of circulation and, as a
result, the supply of money is reduced.” Do you agree? Explain why or why not. LO2
Answer: Students should not agree. The M1 money supply consists of currency
6. “When a commercial bank makes loans, it creates money; when loans are repaid, money is
destroyed.” Explain. LO3
Answer: When a bank makes a loan it also creates a checkable deposit of equal value.
This increase in checkable deposits results in an increase in M1. When we apply this
7. Suppose that Mountain Star Bank discovers that its reserves will temporarily fall slightly below
those legally required. How might it temporarily remedy this situation through the Federal funds
market? Now assume Mountain Star finds that its reserves will be substantially and permanently
deficient. What remedy is available to this bank? (Hint: Recall your answer to question 6.) LO3
Answer: If Mountain Star Bank discovers that its reserves will temporarily fall slightly
below those legally required it can borrow reserves on the Federal funds market to cover
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Chapter 15 – Money Creation
8. Explain why a single commercial bank can safely lend only an amount equal to its excess
reserves but the commercial banking system as a whole can lend by a multiple of its excess
reserves. What is the monetary multiplier, and how does it relate to the reserve ratio? LO4, LO5
Answer: When a bank grants a loan, it can expect that the borrower will not leave
the proceeds of the loan sitting idle in his or her account. Most people borrow to
spend. Therefore the lending bank can expect that checks will be written against
From the above it can be seen why the commercial banking system can safely
lend a multiple of its excess reserves. Whereas one bank loses reserves to other
The algebra underlying the monetary multiplier is that of an infinite geometric
k =1+ b + b2+ b3+.. .. . .+ bn
Solving this for a very large n, we get, k =1/
(
1−b
)
9. How would a decrease in the reserve requirement affect the (a) size of the money multiplier,
(b) amount of excess reserves in the banking system, and (c) extent to which the system could
expand the money supply through the creation of checkable deposits via loans? LO5
Answer: The monetary multiplier is k = 1/(1- required reserve ratio). (a) Thus, a decrease
in required reserve ratio will result in an increase in the multiplier because each bank will
10. LAST WORD Does leverage increase the total size of the gain or loss from an investment, or
just the percentage rate of return on the part of the investment amount that was not borrowed?
How would lowering leverage make the financial system more stable?
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Chapter 15 – Money Creation
Answer:
The term leverage is used in finance to describe how the use of borrowed moneycan mag
nify both profits and losses. Leverage does not increase the total size of the gain or loss
from an investment, because we can assume that a given investment will have the same
Lowering the amount of leverage permitted in investing would make the financial system
more stable because with high leverage, a relatively small loss is magnified greatly and
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consent of McGraw-Hill Education.