Fractional Reserve Banking

6.1.6 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) Fractional Reserve banking means the reserve a bank holds is only a very small portion of its total deposits, while the remaining of money people deposit is loaned out. B. Explain how banks create money under a fractional reserve system. (5 points)

The banks create money by loaning out money that people have deposited in and earn interest differences between borrowing and lending. They only keep a small fraction of the money on hand for liquidity use.

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

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) Whether fractional reserve banking works depends mainly on people’s faith to the system and to the bank. If people no longer hold that faith, the banks are exposed to liquidity risk, since many depositors will ask for their money back at the same time. 2. The Fed plays an umber 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) The three activities of the Fed are, holding deposits for the bank, lending money to the bank, clearing checks between banks.

These activities are to some degree very similar to what bank does to customers, because for banks, it lends money to customers in order to earn interest income. It is also the case for the Fed who lends money to the bank. But the purpose is not only to earn profit, but to mitigate

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) It increases by $6944444.42, the working process is similar to question A. 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) If ARR is 12%, the maximum change in money would be 100,000/0.12, which is $833,333. 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) The activity by bank is called money creation because the central bank and the Fed both rely on banks to implement and enhance the effects. Even though the banks are not directly involved in money supply or money market policy conduction, it does work as a important money creation. 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