Ch. 14 How Banks And Thrifts Create Money

Explanation
The balance sheet of a commercial bank does not show the transactions in which the bank has engaged during a given period of time. Instead, it provides a snapshot of the bank's financial position at a specific point in time by listing its assets, liabilities, and shareholders' equity. The bank's transactions are recorded in its income statement and statement of cash flows, not on the balance sheet.

Explanation
Goldsmiths did not increase the money supply when they accepted deposits of gold and issued paper receipts to the depositors. Instead, they simply provided a convenient way for depositors to store their gold securely and make transactions using the paper receipts. The actual increase in the money supply occurred when these paper receipts began to circulate as a form of currency, which was typically done by individuals who were not goldsmiths. Therefore, the correct answer is false.

Explanation
The statement is incorrect because modern banking systems use "deposits" as the basis for the fractional reserve system, not "hold". The fractional reserve system allows banks to hold only a fraction of the total deposits as reserves and lend out the rest. This system is based on the idea that not all depositors will withdraw their money at the same time, allowing banks to create money through lending. Therefore, the correct answer is False.

Explanation
Cash held by a bank is referred to as vault cash because it is physically held in the bank's vaults for security purposes. This cash is used to fulfill customer withdrawal requests, provide cash for daily operations, and maintain the required reserves. Vault cash is an important asset for a bank as it ensures liquidity and enables the bank to meet its obligations to customers. Therefore, it is correct to say that cash held by a bank is sometimes called vault cash.

Explanation
The explanation for the given correct answer is that when Mary Lynn deposits a $30,000 check in the commercial bank, it becomes a checkable deposit. This increases the bank's reserves by $30,000. Then, when the Manford Iron and Coal Company borrows $30,000 from the same bank, this loan increases the bank's assets by $30,000. As a result, the money supply has increased by $30,000 because the bank now has more funds available to lend out. Therefore, the statement "the money supply has increased by $30,000 as a result of the two transactions" is true.

Explanation
A commercial bank may maintain its legal reserve either as a deposit in its Federal Reserve Bank or as government bonds in its own vault. This statement is false because a commercial bank is required to maintain its legal reserve as a deposit in its Federal Reserve Bank, not as government bonds in its own vault. The legal reserve is a certain percentage of the bank's total deposits that must be held in reserve to ensure liquidity and stability in the banking system.

Explanation
A commercial bank is required to maintain a legal reserve, which is a certain percentage of its deposit liabilities. This legal reserve acts as a buffer to ensure that the bank has enough funds to cover any potential withdrawals by depositors. The required reserve ratio is the percentage of deposits that banks are required to hold in reserve. Therefore, the legal reserve must equal the bank's deposit liabilities multiplied by the required reserve ratio. This ensures that the bank has enough reserves to meet its obligations to depositors. Therefore, the statement is true.

Explanation
Legal reserves refer to the minimum amount of funds that commercial banks are required to hold in reserve, as mandated by the Federal Reserve System. By controlling the level of legal reserves, the Board of Governors can influence the lending ability of commercial banks. If the Board increases the reserve requirements, banks will have less funds available for lending, thus limiting their lending ability. Conversely, if the Board decreases the reserve requirements, banks will have more funds available for lending, thereby increasing their lending ability. Therefore, the statement that legal reserves permit the Board of Governors to influence the lending ability of commercial banks is true.

Explanation
The statement is true because the actual reserves of a commercial bank are calculated by adding the excess reserves (the amount held by the bank above the required minimum) to the required reserves (the minimum amount mandated by the central bank). This total represents the actual reserves held by the bank, which are available to meet customer withdrawals and other obligations.

Explanation
The reserve of a commercial bank in the Federal Reserve Bank is not an asset of the Federal Reserve Bank. Instead, it is a liability of the Federal Reserve Bank because the commercial bank's reserves are held by the central bank. The commercial bank's reserves are considered as assets for the commercial bank itself.

Explanation
When a check for $1000 drawn on Bank X by a depositor is deposited in Bank Y, it does not increase the excess reserves in Bank Y by $1000. Instead, it increases the reserves of Bank Y by $1000, while the deposits of Bank X decrease by the same amount. Excess reserves are the reserves held by a bank above the required reserve ratio, and they are not affected by this transaction. Therefore, the statement is false.

Explanation
The statement is false because a single commercial bank cannot safely lend an amount equal to its excess reserves multiplied by the monetary multiplier ratio. The monetary multiplier ratio determines the amount of money that can be created by the banking system as a whole, not by individual banks. Individual banks have to follow certain regulations and guidelines, such as maintaining a certain level of capital adequacy, when lending money. Therefore, the amount that a bank can safely lend is not solely determined by its excess reserves.

Explanation
When a borrower repays a loan of $500, the supply of money is reduced by $500 because the money that was previously lent out is returned to the lender. This decreases the amount of money in circulation, leading to a decrease in the overall supply of money in the economy. Therefore, the statement is true.

Explanation
When a commercial bank grants a loan of $5000, it increases the money supply because the borrower receives $5000 that they can spend. Similarly, when a commercial bank purchases a $5000 government bond from a securities dealer, it also increases the money supply because the securities dealer receives $5000 that they can spend. Therefore, both actions have the same effect on the money supply, making the statement true.

Explanation
When a commercial bank sells a government bond, it is essentially transferring the ownership of the bond to another entity, such as another bank or an individual. This transaction does not directly impact the money supply because it does not involve the creation or destruction of money. The money supply is typically affected by actions such as the central bank's open market operations, where it buys or sells government bonds to inject or withdraw money from the economy. Therefore, the statement that selling a government bond by a commercial bank increases the money supply is false.

Explanation
A commercial bank seeks both profits and liquidity because it needs to make money by lending out funds and charging interest, while also ensuring that it has enough liquid assets to meet customer demands for withdrawals and other financial transactions. However, these goals can sometimes conflict with each other. For example, if a bank focuses too much on profit-making activities, it may take on excessive risk and have less liquidity available. On the other hand, if a bank focuses too much on maintaining liquidity, it may miss out on profitable lending opportunities. Therefore, it is important for a commercial bank to strike a balance between profits and liquidity.

Explanation
The explanation for the given answer is that the Federal funds rate is not the interest rate at which the Federal government lends funds to commercial banks. Instead, it is the interest rate at which commercial banks lend funds to each other overnight to meet reserve requirements. The Federal Reserve sets a target for the federal funds rate and uses open market operations to adjust the supply of money in order to achieve that target.

Explanation
The statement is true because when a single bank loses reserves, those reserves are not lost to the entire banking system. This means that even though each individual bank can only lend "dollar for dollar" with its excess reserves, the banking system as a whole can lend by a multiple of its excess reserves. This is possible because the reserves lost by one bank can be offset by the reserves gained by another bank, allowing the system to continue lending beyond the individual bank's capacity.

Explanation
The given statement is false. The monetary multiplier is actually the reciprocal of the reserve requirement ratio. It represents the maximum amount of money that can be created by the banking system through the process of deposit creation. Excess reserves divided by required reserves would not accurately calculate the monetary multiplier.

Explanation
The statement is false because the maximum checkable deposit expansion is actually equal to the excess reserves multiplied by the monetary multiplier. The monetary multiplier is a measure of the amount of money that can be created through the banking system based on a given amount of excess reserves. Therefore, the correct formula is: maximum checkable deposit expansion = excess reserves * monetary multiplier.

Explanation
When borrowers from a commercial bank wish to have cash rather than checkable deposits, the money creating potential of the banking system is not increased. In fact, when borrowers withdraw cash, it reduces the bank's reserves and limits their ability to create new loans. Therefore, the statement is false.

Explanation
When banks have a desire to hold excess reserves, it means that they are choosing to keep more money in their reserves instead of lending it out. This reduces the amount of money available for lending and therefore decreases the overall impact of the monetary multiplier. The monetary multiplier is a measure of how much the money supply expands when banks lend out their reserves. So, if banks are holding excess reserves, it reduces the multiplier effect and therefore reduces the size of the monetary multiplier.

Explanation
The explanation for the given correct answer is that profit-seeking banks have a tendency to make changes in the money supply that are pro-cyclical, meaning they increase the money supply during economic booms and decrease it during downturns. This can exacerbate economic fluctuations and lead to instability in the financial system. Therefore, the Federal Reserve System, as the central bank of the United States, plays a crucial role in controlling the money supply to promote stability and regulate the economy.