AP Macroeconomics Page 1 of 2

Assignment: Apply Concepts of Banking and Money Creation

1. The centerpiece of the U.S. economy is its banking system.

A. Banks in the U.S. practice fractional reserve banking. Explain what this means.
(4 points)

B. Explain how banks create money under a fractional reserve system. (5 points)

C. List the two major assets and the main liability of a typical bank operating
under a fractional reserve system. (3 points)

D. Fractional reserve banking is effective as long as two things remain true. What
are those two things, and why does fractional reserve banking depend on
them? (4 points)

2. The Fed plays a number of important roles in the U.S. economy. Among the things it
does is conduct research on the nation's economy and regulate banks.

A. The Fed also acts as a bank for banks. What are the three activities the Fed
undertakes when it acts as a bank for banks? Hint: What are the activities the Fed
does for banks that are similar to the activities a bank does for its customers? (3 points)

B. The Fed also controls the money supply. List and explain the three tools the
Fed uses to control the money supply. (6 points)

3. In exchange for his many years of hard work and devotion, National Corp Inc. gives
Dave $100,000 in T-bonds. Dave sells these bonds to the Fed, and the Fed deposits the
money in Dave's bank account.

A. By how much does the money supply change as a result of this deposit into
Dave's account from the Fed? Explain. (3 points)

B. A bank's actual reserve ratio is the percentage of total deposits a bank actually
holds on to. It is made up of the percentage they are required to hold on to,
known as the required reserve ratio, plus any extra they choose to hold on to.

Suppose Dave's bank has an actual reserve ratio of 12%, and his bank makes a
loan to Darlene based on the funds from Dave's deposit. How much does the
money supply increase as a result of this second step? (3 points)

C. Darlene uses the money to buy a very expensive pair of soccer cleats from
Arthur. Arthur deposits this money in his bank account. His bank holds onto
12% of the deposit and lends the rest out. How much does the money supply
increase as a result of this step? (4 points)

D. In total, by what amount does the original $100,000 that the Fed released into
circulation end up increasing the money supply if every bank holds 12% of its
deposits? (4 points)

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AP Macroeconomics Page 2 of 2
Assignment: Apply Concepts of Banking and Money Creation

E. This example shows the increase in the money supply caused by an increase in
bank deposits. Explain why this activity by banks is called money creation.
(5 points)

4. If a bank becomes worried about the future, it may decide to increase the level of
excess reserves it holds in hopes of avoiding a trip to the Fed's discount window.

A. If a large number of banks increase their excess reserve ratio, or the share of
total deposits held in excess reserve, what effect will this have on the money
supply? Explain your answer. (4 points)

B. If a large number of banks decrease their excess reserve ratio, what effect will
this have on the money supply? Explain your answer. (4 points)

5. Explain why bank runs are a particularly important problem under fractional
reserve systems and the role that the FDIC plays in preventing them. (8 points)

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