The centerpiece of the U.S. economy is its banking system. a. Banks in the U.S.

Question

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)

b. Explain how banks create money under a fractional reserve system. (5 points)

c. List the two major assets and the main liability of a typical bank operating under a fractional reserve system. (3 points)

d. 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)

Explanation / Answer

a) Fractional reserve banking is a banking system in which banks keep certain fraction of their deposits in the form of cash to meet the demand of depositors and lend the remaining amount. Bank does not lend entire amount in the form of loan because any depositor can demand its money to meet their requirement. Additionaly, banks does not keep all their deposits in the form of cash as they have to earn money from that deposits.

b) Suppose new deposits of $ 100 are made in banks. The minimum reserve requirement is being put at 10% of the total deposits now bank will keep a cash reserve equal to $ 10 only and lend the remaining amount of $ 90. For this bank has not to part with its cash reserves, instead borrowers are credit with chequeable deposits. This is the first round creation and equals 90% of the initial deposit. Borrowers will use the depositors to meet their obligation to their debtors, by paying them, most probably in the form of cheques drawn on bank and favouring them the payees of these cheques will deposit the same in their respective bank accounts. The banks give new deposits. They keep 10% of these deposits as cash and lend the remaining amount. In each round, the increase become smaller and smaller and ultimately, it becomes virtually zero. The sum total of all deposits will be $ 1,000.

Deposit multiplier = 1/Reserve Deposit Ratio = 1/10% = 1/0.10 = 10

c) Assets of banks are loan while bank demand deposits are liability of the bank. Bank's have to pay the public deposits when people demand it so it is liability for the banks while loan will provide revenue to the bank in future so it is asset for the bank. Bank reserves are also the assets for the banks while borrowings are the liability of the bank.

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