Chapter 14
MONEY AND THE BANKING SYSTEM
Chapter in a Nutshell
1. Money is the set of assets in the economy that people regularly use to purchase goods and
services from other people. Money has three functions in the economy: It is a medium of
exchange, a unit of account, and a store of value. These functions distinguish money from
other assets such as stocks and bonds, real estate, and the like.
2. Are credit cards money? Not at all! If you use your credit card to make a purchase, you
obtain a short-term loan from the financial institution that issued the card. Credit cards are
thus a method of postponing payment for a brief period. In shopping for a credit card, a
person should want to consider features such as the credit card’s annual percentage rate, the
grace period, whether the issuer may charge an over-limit fee or a late-payment fee, and the
annual cost of the card.
3. The basic money supply (M1) consists of coins, paper money, checking accounts, and
traveler’s checks. Under federal law, only the U.S. Treasury issues coin and the Federal
Reserve System issues paper currency. Checking account money is created by the banking
system.
4. The check collection system in the United States is efficient, but the collection process that a
check goes through may be complicated. The check processing system is conducted by local
clearinghouses, correspondent banks, and the Federal Reserve System=s check collection
network.
5. The U.S. economy has an array of banks, including commercial banks, savings and loan
associations, mutual savings banks, and credit unions. We call these institutions depository
institutions because they accept deposits from people and provide checking accounts that are
part of the money supply.
6. If you save money in a bank, you have alternatives such as money market deposit accounts,
savings accounts, and certificates of deposit. In shopping for an account, it is important to
look at features such as the interest rate, the method of interest compounding, the annual
percentage yield, the timing of interest earned, and fees.
7. A commercial bank is a corporation that seeks to make a profit for its stockholders. Among
the most important assets of a bank are its reserves, loans, and government securities.
Deposits and borrowings are a bank’s major liabilities.
8. Most of our money comes from checking accounts issued by banks, rather than currency.
Through the process of lending reserves, banks create money. The money multiplier is used
to calculate the maximum amount of money the banking system generates with each dollar of
reserves. The money multiplier is the reciprocal of the required reserve ratio.
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Chapter 14: Money and the Banking System
9. The FDIC has insured deposits and promoted safe and sound banking practices since 1934.
The FDIC insures deposits up to $100,000 in virtually all U.S. banks and S & Ls. Since the
start of FDIC insurance, not one depositor has lost a cent of insured funds because of bank
failure.
Chapter Objectives
After reading this chapter, you should be able to:
1. Define money and identify the functions of money.
2. Identify the components of our basic money supply.
3. Describe the collection process a check goes through.
4. Distinguish between the major depository institutions in our economy.
5. Compare the various types of savings accounts which banks offer to their customers.
6. Explain how banks attempt to make a profit for their stockholders.
7. Discuss the process of money creation by the banking system.
8. Identify the purposes of the Federal Deposit Insurance Corporation.
Knowledge Check
Chapter 14: Money and the Banking System
Key Concept Quiz
1. demand deposit
2. share draft account
3. local clearing house
4. near monies
5. M3 money supply
6. depository institutions
7. money-market deposit
accounts
8. required-reserve ratio
9. money multiplier
10. bank run
11. deposit-payoff approach
12. purchase-and-assumption
approach
_____ a. provides a quick and efficient way of collecting
and processing locally drawn checks
_____ b. the reciprocal of the required reserve ratio
_____ c. includes components of M2 plus large time
deposits
_____ d. is specified by the Federal Reserve Bank
_____ e. a regular checking account that does not pay
interest
_____ f. when depositors rapidly withdraw funds from a
bank
_____ g. they accept deposits from people and provide
checking accounts
_____ h. withdrawing funds from this account is usually not
as convenient as doing so from a checking account
_____ i. the most commonly used strategy used by FDIC in
dealing with failed institutions
_____ j. accounts maintained by credit union members
_____ k. interest paying deposits that can be easily
converted into spendable money
_____ l. when the FDIC makes payments to each depositor
up to the insurance limit of $100,000
Multiple Choice Questions
1. All of the following distinguish money from other assets, except
a.
b.
c.
d.
it is a medium of exchange
it is a unit of account
it is a store of value
it is supported by gold reserves
2. All of the paper money in the United States consists of
a.
b.
c.
d.
Federal Reserve notes
Treasury securities
U.S. government securities
commercial notes
3. A regular checking account that doesn’t pay interest is also known as a
a.
b.
c.
d.
demand deposit account
NOW account
certified account
automated teller account
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Chapter 14: Money and the Banking System
4. All U.S. currency
a.
b.
c.
d.
is designated as legal tender
is mostly backed by gold reserves
is partially backed by silver reserves
is printed by the U.S. Treasury
5. The M1 money supply consists of all of the following except
a.
b.
c.
d.
currency in the hands of the public
demand deposits
traveler’s checks
small time deposits
6. Near monies
a.
b.
c.
d.
are interest-paying deposits
are broader measures of money supply
include money-market deposit accounts
all of the above
7. All of the following are true for commercial banks except
a.
b.
c.
d.
they are private corporations
they are not owned by the stockholders
they are often referred to as full-service banks
they were originally formed to make loans to businesses
8. Savings and loan associations
a.
b.
c.
d.
first appeared in the United States in the 1930s
mainly make capital-equipment-purchase loans to businesses
are the largest provider of residential mortgage loans
obtain most of their funds by issuing money market deposit accounts
9. Excess reserves
a.
b.
c.
d.
can be used to make loans
can be used to purchase government securities
equal actual reserves minus required reserves
all of the above
10. The required reserve ratio
a.
b.
c.
d.
is specified by the Federal Reserve
is specified by the U.S. Congress
is specified by the U.S. President
is specified by the U.S. Treasury
11. The maximum amount of money the banking system generates with each dollar of reserves
a. is equal to 1/required reserve ratio
b. is called the money multiplier
c. is determined by the percentage of checking deposits banks are required to hold on
reserve
d. all of the above
Chapter 14: Money and the Banking System
141
12. The greater are currency holdings
a.
b.
c.
d.
the larger the required reserve ratio
the smaller the actual money expansion multiplier
the higher the rate of inflation
the higher the interest rate
13. The FDIC attempts to accomplish all of these goals except
a.
b.
c.
d.
promote safety through examination and audits
insure deposits up to $100,000 in virtually all U.S. banks and S & Ls
arrange disposition of the assets and deposit liabilities of all insured banks that fail
limit investor losses in the stock market
14. The most common strategy used by the FDIC to deal with a failed institution is
a.
b.
c.
d.
the purchase and assumption approach
deposit payoff approach
total liquidation approach
the zero cost approach
15. The liabilities of a bank include all of the following except
a.
b.
c.
d.
savings deposits
deposits at the Federal Reserve
demand deposits
large time deposits
16. Which component of the M1 money supply is “legal tender”?
a.
b.
c.
d.
money market mutual funds
bank credit cards
coin and paper currency
passbook savings accounts
17. Which of the following is not a function of the FDIC?
a.
b.
c.
d.
issues paper currency and coin
examines and audits commercial banks
insures deposits of commercial banks
arranges mergers between sound banks and failing banks
The next three questions are based on the hypothetical balance sheet of U.S. Bank, shown in the
following table.
Balance Sheet of the U. S. Bank
Assets
Liabilities
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Chapter 14: Money and the Banking System
Reserves
Loans
$200,000
60,000
Securities
140,000
Property
100,000
Deposits
Borrowings
from other banks
$400,000
100,000
18. If the required reserve ratio is 10 percent, U.S. Bank has excess reserves of
a.
b.
c.
d.
$40,000
$80,000
$120,000
$160,000
19. U.S. Bank can make new loans of up to
a.
b.
c.
d.
$120,000
$160,000
$200,000
$240,000
20. If this balance sheet was for the commercial banking system, instead of U.S. Bank, loans and
deposits could expand by a maximum of
a.
b.
c.
d.
$1.2 million
$1.4 million
$1.6 million
$1.8 million
21. All of the following monies are legal tender except
a.
b.
c.
d.
nickels, dimes, and quarters
Federal Reserve notes
paper currency
demand deposits
22. According to the concept of compound interest, a saving deposit
a.
b.
c.
d.
loses purchasing power due to inflation
earns interest on interest
pays increasing amounts of interest to wealthy depositors
pays interest during all four quarters of the year
23. What type of check refers to the situation where U.S. Bank signs Mary Smith’s check and
thus guarantees payment on it?
a. money order
Chapter 14: Money and the Banking System
143
b. traveler’s check
c. cashier’s check
d. certified check
24. To Wells Fargo Bank, your checking account is
a.
b.
c.
d.
a liability
an asset
legal tender
a reserve requirement
25. The main emphasis of the M1 money supply is the role of money as a
a.
b.
c.
d.
standard of debt
unit of inflation
store of value
medium of exchange
26. In the United States, coins are issued by
a.
b.
c.
d.
the U.S. Treasury
the Federal Reserve
commercial banks
savings and loan associations
True-False Questions
1.
T
F
M2, and M3 are identical measures.
2.
T
F
The difference between M1, M2 and M3 is that M2 and M3 includes
currency, while M1 does not.
3.
T
F
Most of our money is held in the form of currency.
4.
T
F
Banks create money by lending.
5.
T
F
The larger the currency holdings, the smaller is the money multiplier.
6.
T
F
The larger the required reserve ratio, the smaller is the money multiplier.
7.
T
F
Required reserve ratios are determined by the Treasury Department of
the U.S. government.
8.
T
F
Required reserves can only be held in the form of vault cash by the
banks.
9.
T
F
The largest source of the M1 money supply is the Federal Reserve
System.
10.
T
F
Actual reserves equal excess reserves minus required reserves.
11.
T
F
Traveler’s checks are part of the M1 money supply, but not the M2 money
supply.
12.
T
F
All of our paper currency comes from the U.S. Treasury.
13.
T
F
The money supply in the United States is backed by gold reserves.
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Chapter 14: Money and the Banking System
14.
T
F
The Federal Deposit Insurance Corporation insures bank deposits up to
$1 million.
15.
T
F
Under federal law, only the U.S. Treasury issues coins.
16.
T
F
A credit union is a non-profit institution.
17.
T
F
Savings and loan associations are the largest provider of residential
mortgage loans.
18.
T
F
Near monies are interest-paying deposits that can be easily converted
into spendable money.
19.
T
F
Negotiable order of withdrawal accounts do not pay interest and require
a minimum balance.
20.
T
F
The Federal Reserve is the largest nationwide processor of transit checks.
21.
T
F
Credit cards are a major component of the M1 money supply in the
United States.
22.
T
F
Concerning the calculation of finance charges for credit cards, most
banks use the previous balance method.
23.
T
F
Traveler’s checks, cashier’s checks, and certified checks are legal tender
in the United States.
24.
T
F
Demand deposits are essentially interest-paying checking accounts
issued by commercial banks.
25.
T
F
Certified checks and cashier’s checks have better guarantees of payment
than personal checks.
26.
T
F
The future value of money increases by a greater amount when interest is
compounded on an annual basis rather than a quarterly basis.
27.
T
F
Federal Reserve notes make up all of the paper money issued in the
United States today.
28.
T
F
Rather than issuing checking accounts, credit unions issue share draft
accounts.
29.
T
F
Gold and silver currently provide important sources of “backing” for the
U.S. money supply.
Chapter 14: Money and the Banking System
145
Application Questions
1. Consider the balance sheet of a commercial bank on the Isle of Thrift. This being the only
bank on this island, it constitutes the entire banking system.
Balance Sheet of the Isle of Thrift Bank
Assets
Reserves
Liabilities
$30,000,000
Loans
70,000,000
Total
100,000,000
Deposits
$100,000,000
Total
$100,000,000
If the required reserve ratio on deposits is 20 percent, how much must the bank maintain in
required reserves?
How much excess reserves does the bank have?
What is the total amount of the deposits that the bank can loan out?
What is the value of the money multiplier?
2. Consider another bank that has the same balance sheet as described in question 1. However,
this bank is located on the Isle of Flush, and its reserves requirement is set by a different
central bank. This being the only bank on this island, it constitutes the entire banking system.
a. If the required reserves-to-deposits ratio is 10 percent, how much must this bank
maintain in required reserves?
b. How much excess reserves does this bank have?
c. How much of the excess reserves can this bank loan out?
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Chapter 14: Money and the Banking System
d. What is the money multiplier on the Isle of Flush?
3. Which island will create more money? Explain.
Answers to Knowledge Check Questions
Key Concept Answers
1. e
5. c
2. j
6. g
3. a
7. h
4. k
8. d
9.
10.
11.
12.
Multiple Choice Answers
1. d
6. d
2. a
7. b
3. a
8. c
4. a
9. d
5. d
10. a
11.
12.
13.
14.
15.
b
f
l
i
d
b
d
a
b
16.
17.
18.
19.
20.
c
a
d
b
c
21.
22.
23.
24.
25.
d
b
d
a
d
26. a
Chapter 14: Money and the Banking System
True-False Answers
1. F
6. T
2. F
7. F
3. F
8. F
4. T
9. F
5. T
10. F
11.
12.
13.
14.
15.
F
F
F
F
T
16.
17.
18.
19.
20.
T
T
T
F
T
21.
22.
23.
24.
25.
F
F
F
T
T
26.
27.
28.
29.
147
F
T
T
F
Application Question Answers
1. a. The bank must maintain $20 million in required reserves.
b.
The bank has $10 million in excess reserves.
c.
The bank can loan out $80 million of its deposits.
d.
The value of the money multiplier on the Isle of Thrift is 5.
2. a.
The bank must maintain $10 million dollars in required reserves.
b.
The bank has $20 million in excess reserves.
c.
The bank can loan out all of its excess reserves.
d.
The money multiplier on the Isle of Flush is 10.
3. The bank in the Isle of Flush can create more money because the money multiplier is higher.