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Chapter 15 - Money Creation
15-1
Chapter 15 Money Creation
QUESTIONS
1. 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? LO1
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
2. 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
3. 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
Chapter 15 - Money Creation
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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
through increasing and decreasing excess reserves that the Fed is able to achieve a money
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 outside
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
Chapter 15 - Money Creation
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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
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 the loan and
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
10. LAST WORD Explain how the bank panics of 1930 to 1933 produced a decline in the
nation’s money supply. Why are such panics highly unlikely today?
Chapter 15 - Money Creation
15-4
Answer: Because we have a fractional reserve banking system, bank reserves support a
multiple amount of demand deposit money. When depositors collectively withdraw
PROBLEMS
1. Suppose the assets of the Silver Lode Bank are $100,000 higher than on the previous day and
its net worth is up $20,000. By how much and in what direction must its liabilities have changed
from the day before? LO1
Answer: $80,000 increase.
Feedback: Consider the following example. Suppose that assets of the Silver Lode Bank
are $100,000 higher than on the previous day and its net worth is up $20,000. By how
much and in what direction must its liabilities have changed from the day before?
By definition (balance sheet approach) the total amount of assets must equal liabilities
2. Suppose that Serendipity Bank has excess reserves of $8000 and checkable deposits of
$150,000. If the reserve ratio is 20 percent, what is the size of the bank’s actual reserves? LO2
Feedback: Consider the following example. Suppose that Serendipity Bank has excess
reserves of $8000 and checkable deposits of $150,000. If the reserve ratio is 20 percent,
what is the size of the bank’s actual reserves?
The first step is to calculate the required reserves for the bank, which equals the product
Chapter 15 - Money Creation
15-5
3. The Third National Bank has reserves of $20,000 and checkable deposits of $100,000. The
reserve ratio is 20 percent. Households deposit $5000 in currency into the bank and that currency
is added to reserves. What level of excess reserves does the bank now have? LO3
Answer: $4,000
Feedback: Consider the following example. The Third National Bank has reserves of
$20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent. Households
deposit $5000 in currency into the bank and that currency is added to reserves. What
level of excess reserves does the bank now have?
The first step is to calculate checkable deposits. This equals the original checkable
deposits plus the new deposit, $105,000 (= $100,000 + $5,000).
Excess Reserves = Actual Reserves - Required Reserves = $25,000 - $21,000 = $4,000
4. Suppose again that the Third National Bank has reserves of $20,000 and checkable deposits of
$100,000. The reserve ratio is 20 percent. The bank now sells $5000 in securities to the Federal
Reserve Bank in its district, receiving a $5000 increase in reserves in return. What level of excess
reserves does the bank now have? By what amount does your answer differ (yes, it does!) from
the answer to question 3? LO3
Feedback: Consider the following example. Suppose again that the Third National Bank
has reserves of $20,000 and checkable deposits of $100,000. The reserve ratio is 20
percent. The bank now sells $5000 in securities to the Federal Reserve Bank in its
district, receiving a $5000 increase in reserves in return. What level of excess reserves
does the bank now have? By what amount does your answer differ (yes, it does!) from
the answer to question 3?
The $5,000 sale of securities is directly transferred into the reserves of the bank. This
5. The balance sheet at the top of the next page is for Big Bucks Bank. The reserve ratio is 20
percent. LO3
Chapter 15 - Money Creation
15-6
a. What is the maximum amount of new loans that Big Bucks Bank can make? Show in columns
1 and 1′ how the bank’s balance sheet will appear after the bank has lent this additional amount.
b. By how much has the supply of money changed?
c. How will the bank’s balance sheet appear after checks drawn for the entire amount of the new
loans have been cleared against the bank? Show the new balance sheet in columns 2 and 2′.
d. Answer questions a, b, and c on the assumption that the reserve ratio is 15 percent.
Feedback: Consider the following example. Suppose that Big Bucks Bank has the
simplified balance sheet shown below and that the reserve ratio is 20 percent: LO3
Part a:
What is the maximum amount of new loans that Big Bucks Bank can make? Show in
columns 1 and 1′ how the bank’s balance sheet will appear after the bank has lent this
additional amount.
The first step is to calculate required reserves, which equals the product of the required
Chapter 15 - Money Creation
15-7
Assets
(1) (2)
Liabilities and net
worth
(1) (2)
Reserves
$22,00
$22,000
Checkable deposits
$102,000
_____
Part b:
By how much has the supply of money changed?
The immediate effect is an increase in the money supply by $2,000. Checkable deposits
Part c:
How will the bank’s balance sheet appear after checks drawn for the entire amount of the
new loans have been cleared against the bank? Show the new balance sheet in columns 2
and 2′.
Assets
(1) (2)
Liabilities and net
worth
(1) (2)
Reserves
$22,00
$22,000
$20,000
Checkable deposits
$102,000
$100,000
Part d:
Answer questions a, b, and c on the assumption that the reserve ratio is 15 percent.
Part a: What is the maximum amount of new loans that Big Bucks Bank can make? Show
in columns 1 and 1′ how the bank’s balance sheet will appear after the bank has lent this
Chapter 15 - Money Creation
15-8
Assets
(1) (2)
Liabilities and net
worth
(1) (2)
Reserves
$22,00
$22,000
Checkable deposits
$107,000
_____
Part b: By how much has the supply of money changed?
The immediate effect is an increase in the money supply by $7,000. Checkable deposits
have increased by $7,000 (note that we have not worked through the monetary multiplier
yet, this is the immediate effect of the transaction.)
Assets
(1) (2)
Liabilities and net worth
(1) (2)
Reserves
$22,00
$22,000
$15,000
Checkable deposits
$107,000
$100,000
6. Suppose the simplified consolidated balance sheet shown below is for the entire commercial
banking system and that all figures are in billions of dollars. The reserve ratio is 25 percent. LO5
Chapter 15 - Money Creation
15-9
a. What is the amount of excess reserves in this commercial banking system? What is the
maximum amount the banking system might lend? Show in columns 1 and 1′ how the
consolidated balance sheet would look after this amount has been lent. What is the size of the
monetary multiplier?
b. Answer the questions in part a assuming the reserve ratio is 20 percent. What is the resulting
difference in the amount that the commercial banking system can lend?
Feedback: Consider the following example. Suppose the simplified consolidated balance
sheet shown below is for the entire commercial banking system and that all figures are in
billions of dollars. The reserve ratio is 25 percent. LO5
Part a:
What is the amount of excess reserves in this commercial banking system? What is the
maximum amount the banking system might lend? Show in columns 1 and 1′ how the
consolidated balance sheet would look after this amount has been lent. What is the size of
the monetary multiplier?
The first step is to calculate required reserves, which equals the product of the required
reserve ratio (decimal from) and checkable deposits.
Chapter 15 - Money Creation
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Assets
(1)
Liabilities and Net Worth
(1’)
Reserves
$ 52
$52
Checkable deposits
$200 $208
Two things to note here: (1) The banking system does not lose reserves (1’) checkable
deposits increase by the amount of the loans (money creation through the fractional
reserve banking system).
Part b:
Answer the questions in part a assuming the reserve ratio is 20 percent. What is the
resulting difference in the amount that the commercial banking system can lend?
We follow the same steps, but with a required reserve ratio of 20 percent.
The first step is to calculate required reserves, which equals the product of the required
Assets
(1)
Liabilities and Net Worth
(1’)
Reserves
Securities
$ 52
48
$52
48
Checkable deposits
$200 $260
7. If the required reserve ratio is 10 percent, what is the monetary multiplier? If the monetary
multiplier is 4, what is the required reserve ratio? LO5
Chapter 15 - Money Creation
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Answers: 10; 25 percent.
Feedback: Consider the following example. If the required reserve ratio is 10 percent,
what is the monetary multiplier? If the monetary multiplier is 4, what is the required
reserve ratio?
The monetary multiplier equals one divided by the required reserve ratio.
