๐ง Quick Study Guide: Fractional Reserve Banking
- ๐ก Definition: ๐ฆ Fractional reserve banking is a system where banks hold only a fraction of customer deposits as reserves and lend out the rest. This allows banks to create money through lending.
- ๐ Reserve Requirement (RR): ๐ The percentage of demand deposits that banks are legally required to hold in reserve, either in their vaults or at the Federal Reserve.
- ๐ฐ Excess Reserves (ER): ๐ต The amount of reserves a bank holds above the legally required minimum. These are the funds available for lending. Formula: $ER = \text{Total Reserves} - \text{Required Reserves}$.
- ๐ข Money Multiplier: ๐งฎ The maximum amount of new money that can be created in the banking system for every dollar of excess reserves. Formula: $\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement (as a decimal)}}$.
- ๐ Deposit Expansion Process: ๐ธ An initial deposit leads to a series of loans and re-deposits throughout the banking system, expanding the money supply by a multiple of the initial deposit.
- ๐ก๏ธ Bank Balance Sheets (T-Accounts): ๐ A simplified accounting statement showing a bank's assets (e.g., reserves, loans) and liabilities (e.g., deposits). Assets must equal Liabilities + Owner's Equity.
โ Practice Quiz: Fractional Reserve Banking Concepts
Choose the best answer for each question.
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Which of the following best describes fractional reserve banking?
A. Banks are required to hold 100% of their deposits as reserves.
B. Banks hold a fraction of deposits as reserves and lend out the rest.
C. Banks can only lend money they have borrowed from the Federal Reserve.
D. Banks are prohibited from creating new money through lending.
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If the reserve requirement is 20% and a bank receives a new deposit of $1,000, how much can the bank immediately lend out?
A. $200
B. $800
C. $1,000
D. $5,000
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What is the formula for the simple money multiplier?
A. $1 - \text{Reserve Requirement}$
B. $\text{Reserve Requirement} \times \text{Deposits}$
C. $\frac{1}{\text{Reserve Requirement}}$
D. $\frac{\text{Deposits}}{\text{Reserves}}$
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A bank has $10,000 in demand deposits and holds $2,000 in reserves. If the reserve requirement is 10%, what are the bank's excess reserves?
A. $1,000
B. $2,000
C. $9,000
D. $1,000
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If the reserve requirement is 25%, and the banking system receives a new deposit of $4,000, what is the maximum potential increase in the money supply for the entire banking system?
A. $1,000
B. $4,000
C. $12,000
D. $16,000
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Which of the following actions by the Federal Reserve would increase the money supply?
A. Selling government bonds on the open market.
B. Increasing the reserve requirement.
C. Increasing the discount rate.
D. Buying government bonds on the open market.
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Which factor is most likely to limit the actual money multiplier from reaching its theoretical maximum?
A. Banks lending out all of their excess reserves.
B. Individuals holding a larger portion of their money as cash rather than depositing it in banks.
C. A decrease in the reserve requirement.
D. The Federal Reserve buying more government bonds.
Click to see Answers
- B. Banks hold a fraction of deposits as reserves and lend out the rest.
- B. $800 ($1,000 deposit - $200 (20% required reserves) = $800 excess reserves)
- C. $\frac{1}{\text{Reserve Requirement}}$
- A. $1,000 (Required reserves = $10,000 * 0.10 = $1,000. Excess reserves = $2,000 - $1,000 = $1,000.)
- C. $12,000 (Money multiplier = $1/0.25 = 4. Potential total money supply created = $4,000 * 4 = $16,000. The increase in money supply is $16,000 - $4,000 (original deposit) = $12,000.)
- D. Buying government bonds on the open market.
- B. Individuals holding a larger portion of their money as cash rather than depositing it in banks.