Banking and the Expansion of the Money Supply

Noah Martinez

9 min read

Study Guide Overview

This study guide covers fractional reserve banking, the money multiplier, and bank balance sheets (T-accounts). Key concepts include the reserve ratio, required reserves, excess reserves, calculating the money multiplier, and analyzing how changes in deposits and the reserve ratio affect the money supply. It also provides practice questions and a real FRQ example with answers to help prepare for the AP Macroeconomics exam.

#AP Macroeconomics: Banking and the Money Multiplier 🏦

Hey future economist! Let's break down banking and the money multiplier. This is a high-value topic that appears frequently on the AP exam, so let's make sure you've got it down pat!

#🏦 Fractional Reserve Banking: The Magic of Money Creation

Key Concept

Fractional reserve banking is the backbone of how banks operate. They don't keep all your deposits in a vault; instead, they loan out most of it, which creates new money in the economy. It's like a financial magic trick! ✨

Banks: Financial institutions that accept deposits and make loans.
Fractional Reserve Banking: Banks hold only a fraction of deposits as reserves and loan out the rest.
Reserve Ratio (rr): The fraction of deposits banks are required to keep as reserves, set by the Federal Reserve (the Fed).
- Also known as the reserve requirement.
Required Reserves: The amount of money banks must keep in their vaults or at the Fed.
Excess Reserves: The amount of money banks can loan out.

#How it Works

You deposit money into a bank.
The bank keeps a percentage (the reserve ratio) as required reserves.
The bank loans out the rest as excess reserves.
This loan becomes someone else's deposit, and the process repeats.

Fractional Reserve Banking

Caption: A visual representation of how fractional reserve banking works. Deposits are partially held as reserves and the rest is loaned out, creating new money.

#Calculating Reserves

Let's look at the following table to understand how to calculate reserves:

Calculating Reserves

Caption: This table shows how to calculate required and excess reserves based on different demand deposits and reserve ratios.

Practice Question

Multiple Choice Questions:

If the reserve requirement is 20%, what is the money multiplier? (A) 2 (B) 4 (C) 5 (D) 10 (E) 20
A bank has $100,000 in deposits and a reserve requirement of 10%. How much is the bank required to keep in reserves? (A)$ 1000 (B) $10,000 (C)$ 90,000 (D) $100,000 (E)$ 110,000

#💰 The Money Multiplier: How Much Money Can Be Created?

The money multiplier shows how much the money supply can expand from an initial deposit. It's a crucial concept for understanding monetary policy.

Money Multiplier Formula: $\frac{1}{Reserve Ratio (rr)}$

#How it Works:

A lower reserve ratio means a larger money multiplier and a greater potential change in the money supply. ⬆️
A higher reserve ratio means a smaller money multiplier and a smaller potential change in the money supply. ⬇️

#Examples

Let's see how the money multiplier works with a couple of examples:

Example One: Reserve ratio of 20% (0.2), money multiplier = 5 (1/0.2)

Example One

Example One Calculations

Example Two: Reserve ratio of 50% (0.5), money multiplier = 2 (1/0.5)

Example Two

Example Two Calculations

Memory Aid

Remember: A low reserve ratio = high multiplier = big change in money supply. Think of it like a small leak causing a big flood! 🌊

#Total Change in the Money Supply

To find the maximum change in the money supply, multiply the initial change in excess reserves by the money multiplier.

Total Change

Total Change Calculations

Practice Question

Multiple Choice Questions:

If a bank receives a new deposit of $100 and the reserve requirement is 25%, what is the maximum amount that the money supply can increase? (A)$ 25 (B) $75 (C)$ 300 (D) $400 (E)$ 500
Which of the following would cause the money multiplier to increase? (A) An increase in the reserve requirement (B) A decrease in the reserve requirement (C) An increase in the discount rate (D) A decrease in the discount rate (E) An increase in the federal funds rate

#🧾 Bank Balance Sheets (T-Accounts)

Key Concept

Bank balance sheets (or T-accounts) are like a snapshot of a bank's financial health. They show assets and liabilities, which must always balance. Understanding how these accounts work is crucial for the FRQs!

Liabilities: What the bank owes to others (e.g., deposits).
Assets: What the bank owns (e.g., reserves, loans).

#Key Components

Demand Deposits: Money held in checking accounts (a liability for the bank).
Required Reserves: Money the bank is legally required to keep (an asset).
Excess Reserves: Money the bank can loan out (an asset).
Loans: Money the bank has lent out (an asset).

#Example

Here's a sample bank balance sheet:

Bank Balance Sheet

Caption: This T-account shows how a bank uses deposits to create reserves and loans. Notice that assets always equal liabilities.

#How to Analyze a T-Account

Start with Deposits: Look at the total demand deposits.
Calculate Required Reserves: Multiply deposits by the reserve ratio.
Find Excess Reserves: Subtract required reserves from total deposits.
Determine Potential Loans: Excess reserves are what the bank can loan out.
Calculate Change in Money Supply: Multiply excess reserves by the money multiplier.

Exam Tip

On the exam, always make sure that your T-account balances! Assets should always equal liabilities. This is a quick check to avoid losing easy points.

Practice Question

Free Response Question (FRQ):

Use the following Bank Balance Sheet for First Superior Bank:

Assets	Liabilities
Required Reserves	Demand Deposits $2000$
Loans
Total Assets	Total Liabilities

Assume that the required reserve ratio is 20 percent.

(a) What is the dollar value of required reserves for First Superior Bank? Explain. (b) What is the dollar value of new loans that First Superior Bank can make? Explain. (c) Suppose a customer deposits500 of cash into a demand deposit account in First Superior Bank. Calculate the maximum amount of new loans that First Superior Bank can now make. (d) As a result of the $500 cash deposit, calculate the maximum change over time in the money supply in the banking system. (e) Provide one reason why the actual change in the money supply can be smaller than the maximum change you identified in part (d).$

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#📝 Practice FRQ: 2016 #2 (with answers)

Let's tackle a real FRQ to see how well you've grasped these concepts!

FRQ 2016

#Answers:

(a) The amount of new loans is zero because the bank has no excess reserves. All excess reserves have already been loaned out.

(b) The maximum amount of new loans that can be made is90. $10 will be the required reserves (10% of$ 100), and $90 will be the excess reserves that can be loaned out.$

(c) - (i) The maximum change over time in loans in the banking system is900 ( $90 x 10, the money multiplier). - [object Object] The maximum change over time in demand deposits in the banking system is$ 1000 ( $100 x 10, the money multiplier).$

(d) The maximum change over time in the money supply is900 ($90 x 10).

(e) The money supply can be smaller than the maximum change if the public holds more cash or if banks hold more excess reserves.

Common Mistake

A common mistake is confusing the change in demand deposits with the change in the money supply. Remember, the money supply only changes by the amount of new loans created, not the total deposits.

#🎯 Final Exam Focus

Okay, you're almost there! Here's what to focus on for the exam:

Fractional Reserve Banking: Understand how banks create money.
Money Multiplier: Master the formula and its implications.
Bank Balance Sheets: Know how to analyze T-accounts and calculate changes in reserves and loans.
Impact of Reserve Ratio: How changes in the reserve ratio affect the money supply.

#Last-Minute Tips

Time Management: Don't spend too long on one question. If you're stuck, move on and come back later.
FRQ Structure: Clearly label each part of your answer and show all your work.
Common Pitfalls: Double-check your calculations and make sure your T-accounts balance.
Stay Calm: You've got this! Take a deep breath and trust your preparation.

Quick Fact

Remember: The money multiplier works in reverse too! If people withdraw money from banks, the money supply can contract by the same multiple.

You've got this! Go ace that exam! 🚀