Test Your Knowledge Fractional Reserve Banking Click on the letter choices to test your understanding ABC

Question 1 Fractional reserve banking is a concept that is predominantly used only in the U.S. A that was created by the Federal Reserve during the Great Depression. B that dates back to the 17 th century and is still used worldwide. C

Try again! Banks in almost all countries of the world practice this form of banking. Back

Try again! According to a common story about the origin of banking, fractional reserve banking has been practiced since the 17 th century. Depositors of gold and silver coins would receive bank notes as a claim on their deposit from the depositories (banks). As bankers realized all depositors would not make claims on their gold or silver at one time, they began issuing interest bearing loans against a fraction of the gold and silver deposits. Back

Correct! According to a common story about the origins of banking, fractional reserve banking dates back to the 17 th century. This practice enables banks to hold only a fraction of all deposits as reserves that are available for withdrawals. Banks use the remaining fraction of deposits to make new loans; charging interest on those loans. Next

Question 2 Banks earn profits by charging a higher interest rate on money loaned than the interest rate paid on deposits held. A increasing their holdings of reserves and decreasing their lending. B lending to the Federal Reserve at the discount rate. C

Correct! Known as the net interest spread, banks charge higher rates of interest for lending than they pay customers for interest bearing deposits. Banks earn profits through this business practice. Next

Try again! Increasing bank holdings of reserves and decreasing bank lending will result in higher nominal interest rates and lower levels of borrowing by businesses and individuals. This will lead to lower overall bank revenues. Back

Try again! The Federal Reserve charges banks interest on overnight lending, also known as the discount rate. The Federal Reserve serves as the lender of last resort to financial institutions that face financial difficulties. Back

Question 3 The money supply includes all currency in circulation. A a fraction of currency in circulation B all currency in circulation plus the total deposits in depository institutions. C

Try again! All currency in circulation is only one component of the money supply. Back

Try again! All currency in circulation is only one component of the money supply. Back

Correct! M-1, one standard measure of the money supply, includes all currency in circulation plus the demand deposits, checkable deposits, at depository institutions (financial institutions that acquire their deposits from the public, i.e. commercial banks, credit unions, savings and loan associations, and savings banks). Next

Question 4 Required reserves are the fraction of deposits that commercial banks hold to meet customer demands for liquidity. A that commercial banks lend out to earn profits. B that commercial banks hold as required by the FDIC. C

Correct! In order to meet customer demands for cash withdrawals banks are required to hold a fraction of all deposits as bank reserves. This enables banks to meet the liquidity demands for their customers. Next

Try again! Banks earn profits by charging a higher interest rate on money loaned than the interest rate paid on deposits held. Back

Try again! The FDIC, the Federal Deposit Insurance Corporation, does not set the required reserve ratio which establishes the fraction of deposits that banks must hold to meet customer demands for liquidity. Back

Question 5 The required reserve ratio is set by the Federal Reserves Board of Governors. A varies by state. B is a regularly used tool of monetary policy. C

Correct The Board of Governors of the Federal Reserve has the sole authority to set the required reserve ratio thus making changes to the reserve requirements. Next

Try again! Based on limits that have been established by law, state governments do not have the authority to set reserve requirements. Back

Try again! The least commonly used tool of monetary policy is making changes to the required reserve ratio. The last time the Fed used this tool to implement an expansion of the money supply was in April Back

Question 6 Excess reserves are reserves that exceed the capacity of a banks vaults. A the total amount of money in circulation outside the United States. B the amount of money left for lending after the reserve requirement is met. C

Try again! Excess reserves are not determined by the capacity of a banks vaults. Back

Try again! While the majority of currency in circulation is held outside the United States this currency does not represent the excess reserves banks hold. Back

Correct! After banks have met their reserve requirements the amount of money that is available for lending is known as excess reserves. Next

Question 7 Which of the following is correct? a decrease in the reserve requirement means there is more money available to lend, so the money supply expands. A a decrease in the reserve requirement means there is less money available to lend, so the money supply contracts. B an increase in the reserve requirement means there is more money available to lend so the money supply expands. C

Correct! When the reserve requirement is lowered by the Fed banks are required to keep a smaller fraction of their deposits on reserve. This increases the amount of excess reserves that will be available for lending. This will result in an expansion of the money supply. Next

Try again! The money supply contracts when the reserve requirement is raised by the Fed. Back

Try again! When the Fed raises the reserve requirement the money supply contracts. The increase in the reserve requirement results in less money being available as excess reserves that can be in turn lent out by financial institutions. Back

Question 8 The simple money multiplier is calculated as 10 times the initial deposit amount. A 1 divided by the required reserve ratio. B the required reserve ratio divided by the initial deposit amount. C

Try again! This would lead to a greater increase of the money supply relative to a corresponding expansion of the monetary base. Banks may lend out only a fraction of all monies deposited. Back

Correct! The simple money multiplier is the reciprocal of the reserve requirement. The higher the reserve requirement the lower the simple money multiplier. The lower the reserve requirement the higher the simple money multiplier. When banks have to hold a larger fraction of deposits as required reserves the amount by which the money supply can expand relative to the monetary base is diminished. Next

Try again! This would result in a greater corresponding increase in the money supply. Back

Question 9 The Money Creation formula is stated as 1 divided by the required reserve ratio. A Excess reserves divided by the simple money multiplier B The simple money multiplier times excess reserves. C

Try again! The simple money multiplier is calculated as 1 divided by the required reserve ratio. Back

Try again! Dividing excess reserves by the simple money multiplier will result in a number 100 times less than the correct application of the money creation formula has the potential to generate. Back

Correct! When there are no leakages to the money creation process multiplying excess reserves by the simple money multiplier will result in an expansion of the money supply greater than a corresponding increase in the monetary base. Next

Question 10 Calculate the maximum money creation potential of a $1000 deposit when there is a 20% required reserve ratio. $1,000 is expanded by $4,000 to become $5,000 of potential money creation. A $1,000 is expanded by $9,000 to become $10,000 of potential money creation. B $1,000 is expanded by $2,000 to become $3,000 of potential money creation. C

Correct! The simple money multiplier for a 20% required reserve ratio is 5.(The reciprocal of the required reserve ratio.) When that 5 is multiplied by the $800 of excess reserves available for lending the result is $4,000 of money added to the initial $1,000 deposit for a total potential money creation of $5,000. Next

Try again! A 10% required reserve ratio would have the potential to turn a $1,000 deposit into $10,000 new money through a $9,000 expansion. Back

Try again! An expansion of a $1,000 deposit by $2,000 for a potential $3,000 of new money would indicate that the required reserve ratio is 50% resulting in a simple money multiplier of 2. Back

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