Special Note on Capital Requirements. This does not always show up on the AP exam, but if it
does, I want you to be aware of how it works. Capital requirements are an additional tool of the
Federal Reserve to guard against loss in a bank run. The AP exam will define capital requirements
as an easy percentage like 5, 10, 20 or 25% of all reserves. Assuming a $10,000 deposit, with a 10%
capital reserve requirement, and a 20% required reserve requirement, the T-account would look like
this:
Assets
Required Reserve
Capital Reserve
Excess Reserve
$2,000 Deposits
$1,000
$7,000
Liabilities
$10,000
Questions based on such a scenario will likely ask about how much you can loan out, assuming the
bank keeps no excess reserves. That would be the maximum, and that would be $7,000.
Special Note on Monetary Base vs.
Monetary Supply There is a difference
between the monetary base and the monetary
supply. The monetary base consists of all bank
reserves and currency in circulation. Think of it
as the potential of available money. Money
supply refers to currency in circulation and
checkable bank deposits. Think of it as the
actual amount of money in the economy.
These questions typically are a pain in the butt.
The way it’ll show up is in multiple choice answers saying the monetary base does X or the money
supply does Y. Additionally, it will give a statement, honest to God, that says that the economy
consists solely of checkable bank deposits, that is, no cash.
Table 2. Assets and Liabilities.
Assets
Loans
$900,000
Reserves
$100,000
Use Table 2 to answer question 1.
Deposits
Liabilities
$1,000,000
1. If the reserve ratio is 10%, and the bank is holding no excess reserves, how much money will be
added to the money supply?
a. $10,000,000
b. $9,000,000
c. $1,000,000
d. $2,000,000
e. $900,000
This question is asking you to apply the money multiplier, found by 1/rr. The required reserve ratio
is 10%, so 1/0.10 = 10. Applying the money multiplier to the loans made here, (10)($900,000) =
$9,000,000. The answer is B.
2. Suppose a bank receives a $5,000 deposit, and the reserve ratio is 25%. The bank is required to
keep in reserve an amount equal to:
a. $200.
b. $1,000.
c. $1,250.
d. $500.
e. $1,500.
This is asking what the required reserve would be of $5,000, assuming a 25% ratio. ($5,000)(0.25) =
$1,250. The answer is C.
3. Suppose your grandmother sends you $100 for your birthday and you deposit $100 into your
checking account at the local bank. The reserve ratio is 10%. Based upon this deposit, the
bank's reserves have increased by _____ and the bank's checkable deposits have increased by
_____.
a. $100; $100
b. $100; $90
c. $90; $100
d. $10; $100
e. $110; $100
The answer here is tricky because nothing has been loaned out. The T-account would look like this:
Assets
Excess Reserves
Liabilities
$100 Deposits
$100
As such, the answer would be A.
Scenario 1. Money Creation. The reserve requirement is 20%, and Tyler deposits his $1,000
check received as a graduation gift in his checking account. The bank does NOT want to hold
excess reserves.
Use Scenario 1 to answer questions 4 and 5.
4. Which of the following is an accurate description of the bank's balance sheet immediately after
the deposit?
a. Reserves increase by $1,000, and demand deposits increase by $1,000.
b. Reserves increase by $1,000, and demand deposits increase by $1,000.
c. Reserves decrease by $1,000, and demand deposits decrease by $1,000.
d. Reserves decrease by $200, and demand deposits increase by $1,000.
e. Reserves increase by $800, and demand deposits increase by $1,000.
This is a similar analysis to #13. Nothing indicates anything has been loaned out. The T-account
would look like this:
Assets
Excess Reserves
Liabilities
$1,000 Deposits
$1,000
As such, the answer would be A.
5. What is the maximum expansion in the money supply possible?
a. $1,000
b. $1,800
c. $4,000
d. $5,000
e. $10,000
This is asking you to do two things. First, assume that the bank has no excess reserves—that it
loans out all it can. Second, apply the required reserve ratio to find the excess reserves. Third, find
the money multiplier. Fourth, use the money multiplier against the money supply to find the
maximum amount of expansion. Did I say two things? I meant four.
Required reserve ratio is 20%, and 20% of $1,000 is $200. $200 is the required reserve, meaning that
the remaining $800 is the excess reserves. The money multiplier is 1/rr, which is 1/0.20, which is 5.
(5)($800) = $4,000. The answer is C.
Practice Problems
1. Given the following T-account and assuming the bank holds no excess reserves, what is the
required reserve ratio?
Assets
Required Reserves
Loans
Treasury bills
a.
b.
c.
d.
Liabilities
$100 Deposits
$400
$800
10%
40%
80%
1%
2. Using the same T-account, how much capital does this bank currently hold?
a. Zero
b. $300
c. $400
d. $500
e. $1,300
3. The monetary base consists of
a. Currency in circulation plus bank deposits.
b. Bank deposits plus bank reserves.
c. Bank deposits, bank reserves and currency in circulation.
d. Currency in circulation plus bank reserves.
$1,000
4. In a simple banking system, where banks hold no excess reserves and all funds are kept as bank
deposits, then
a. The money multiplier equals 1 divided by the required reserve ratio.
b. Total deposits will equal reserves multiplied by the reciprocal of the required reserve ratio.
c. $1 increase in excess reserves will increase deposits by an amount equal to 1 divided by the
required reserve ratio.
d. All of the above.
5. A bank run can “break a bank” because:
a. Borrowers default on their loans, and the bank’s assets become worthless.
b. Banks can not convert quickly illiquid loans into liquid assets without facing a large financial
loss.
c. Depositors’ panic spreads to borrowers, who want to take additional loans from the bank.
d. The bank’s reserves kept with the Federal Reserve are in the form of illiquid U.S. Treasury
bonds.
e. The banks cannot quickly convert liquid assets like checking deposits to cover illiquid
liabilities like loans.
6. Suppose that there are no excess reserves in the banking system and the current amount of
demand deposits are equal to $100,000. Now the monetary authorities lower the required
reserve ratio from 10% to 5%. Which of the following will likely follow?
a. The amount of excess reserves in the banking system will fall.
b. The amount of excess reserves in the banking system will remain the same.
c. The money creating potential of the banking system will decline.
d. The money creating potential of the banking system will rise.
e. The amount of required reserves in the banking system will rise.
Scenario. The reserve requirement is 20%, and Andrea deposits her $1,000 check received as a
graduation gift in her checking account. The bank does not want to hold excess reserves.
7. Which of the following is an accurate description of the bank’s balance sheet immediately after
the deposit?
a. Reserves increase by $1,000, and demand deposits increase by $1,000.
b. Reserves increase by $1,000, and demand deposits decrease by $1,000.
c. Reserves decrease by $1,000, and demand deposits decrease by $1,000.
d. Reserves decrease by $200, and demand deposits increase by $1,000.
e. Reserves increase by $800, and demand deposits increase by $1,000.
8. How much of the deposit is the bank required to keep in reserves?
a. $1,000
b. $100
c. $200
d. $800
e. $250
9. How much can the bank loan based on the $1,000 deposit?
a. $1,000
b. $200
c. $800
d. $0
e. $900
10. What is the maximum expansion in the money supply possible?
a. $1,000
b. $1,800
c. $4,000
d. $5,000
e. $10,000
Answer Key
1. Answer: A. The required reserve ratio is a percentage of deposits made. Deposits are $1,000
and the require reserve is $100. 10%.
2. Answer: B. This is a tricky question because of the language, it’s asking for “capital.” Capital
is the difference between total assets and liabilities. Bank capital = Assets – Liabilities. $1,300 $1,000 = $300.
3. Answer: D. This is definitional. Monetary base consists of currency and bank reserves.
Money supply equals currency plus bank deposits.
4. Answer: D. These are all restatements of the required reserve ratio and the relationship with
excess reserves.
5. Answer: B. Roughly, B translates to banks can get people their money fast enough without
taking a big financial hit, as in borrow from the Federal Reserve or other commercial banks. A
is wrong. Bank runs are about confidence in the bank, not borrowers’ ability to pay back loans.
C is wrong, oh God, is it wrong. Seriously? Depositors freak out, then borrowers freak out,
then borrowers decide, “Well, I know the bank is insolvent. I guess it’s time to borrow more
money from it.”? Seriously? Seriously. D is wrong. It’s just simply not true, or at least, nothing
indicates that the bank has put its excess reserves in T-bills. E is wrong, but it’s odd. E actually
describes what a bank run is. The question is asking why bank runs hurt banks though. E is a
really good distractor.
6. Answer: D. If you lower the required reserve ratio, the amount of money to be held in reserve
is reduced, meaning banks can lower more. If banks can loan more, more money can be created.
C is wrong for this reason, and D is right. A and B are wrong for the same reason. The
required reserve ratio dropped from 10% to 5%, which means that the amount of excess
reserves would automatically increase. E is wrong because if you lower the required reserve ratio,
the amount of required reserves must decrease.
7. Answer: A. Nothing indicates a loan has been made. The question asks specifically what
happens immediately after the deposit. Both reserves and demand deposits would have to
increase by $1,000.
8. Answer: C. The reserve requirement is 20%. 20% of $1,000 is $200. Math. It works, punks.
9. Answer: C. The reserve requirement is 20%, meaning the amount of $200 must be kept. The
remaining $800 can be loaned out. Math. It works, punks.
10. Answer: C. The reserve requirement is 20%, meaning that the money multiplier is 1/0.20,
which is 5. $800 can be loaned out. ($800)(5) = $4,000. Math. It works, punks.