1. AP Macroeconomics How Banks Create of Money FRQ – 2011 #3; 2009 #3; 2009B #2; 2006B #2

2. Banks can create money!  When you deposit money in a checking account at the bank, does the bank have to keep all your money in the bank vault?  The FED requires that banks keep only a certain percentage of your money in the bank vault or on deposit at the FED.

3. Reserve Ratio (Requirement)  The percent that must be kept in the bank vault or on deposit at the FED is the required reserve ratio or reserve requirement.  For example, if the RR is 20%, the bank must keep $200 of your $1000 deposit in the bank vault.  What can the bank do with the other $800 (excess reserves)?

4. So – how do banks create $? BankDepositRRERLoan A$1000$200$800 B $160$640 C $128$512 D $102.4$409.6 E ……… F………… …………… Total Amount of $ created by banking system: $4000

5. Money Creation Formula  A single bank can create $ by the amount of its excess reserves.  The banking system as a whole can create $ by a multiple of the excess reserves.  MM X ER = Expansion of money  Money Multiplier = 1/RR  Ex. If RR = 20% MM = 1/.20 = 5  If $1000 is deposited in bank, required reserves are $200; excess reserves are $800.  The banking system as a whole can create:  5 X $800 = $4000.

6. New vs Existing $  If the initial deposit in a bank comes from the FED or bank purchase of a bond or other money out of circulation (buried treasure), the deposit immediately increases the money supply.  The deposit then leads to further expansion of the money supply through the money creation process.  Total change in MS if initial deposit is new $ = Deposit + $ created by banking system. = Deposit + $ created by banking system.

7. New vs. Existing $  If a deposit in a bank is existing $ (already counted in M1; ex. Currency or checks), depositing the amount does NOT change the MS immediately because it is already counted.  Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking account deposits.  Total change in the MS if deposit is existing $ = banking system created money only.

8. Factors that weaken the effectiveness of the deposit multiplier:  If bank customers take their loans in cash rather than in new checking account deposits. (cash or currency drains)  If banks fail to loan out all their excess reserves.  https://www.youtube.com/watch?v=hcMXJmymZg0&list=PLD7C33A B80B405B9A https://www.youtube.com/watch?v=hcMXJmymZg0&list=PLD7C33A B80B405B9A https://www.youtube.com/watch?v=hcMXJmymZg0&list=PLD7C33A B80B405B9A  Quiz practice https://www.youtube.com/watch?v=6OpzAD9Okds&list=PLD7C33A B80B405B9A Quiz practice https://www.youtube.com/watch?v=6OpzAD9Okds&list=PLD7C33A B80B405B9A Quiz practice https://www.youtube.com/watch?v=6OpzAD9Okds&list=PLD7C33A B80B405B9A