Week 9 · Chapter

Chapter 9 — Money & the Banking System

Principles of Macroeconomics Free sample edition

The module's primary reading · ~35–45 minutes · Objective 7 (explain money, banking, and monetary policy — the functions of money, how fractional-reserve banking creates money and the money multiplier, the Federal Reserve's goals and tools, the money market, and the transmission mechanism from the money supply to interest rates, investment, and aggregate demand), with Objective 6 (analyze fiscal policy — government spending, taxes, expansionary and contractionary stances, and automatic stabilizers — apply the spending and tax multipliers, and distinguish the deficit (a flow) from the national debt (a stock)) · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

This week is about money: what it is, how much of it there is, and where most of it comes from. Money (anything people generally accept as payment) does three everyday jobs for you, and it is not the same thing as being rich. Most of the money you spend is not paper cash at all; it is bank deposits. Banks create new deposits when they make loans, through fractional-reserve banking (banks keep only part of each deposit and lend out the rest). By the end of the week you can trace one deposit through a chain of banks and say how much new money the chain can create at most.

Why you already care about this

Think about an illustrative week of your own money. You may have tapped a card for a 3-dollar coffee, paid a 2-dollar bus fare, and moved 50 dollars from checking into savings. Not one of those moves needed a paper bill. Yet each one used money, and each one depended on a bank keeping track of who owns what.

Now think about where that money came from. A paycheck landed in your account because your employer's bank moved it there. Your employer may have borrowed from a bank to make payroll during a slow month. When a bank makes a loan, it does not hand over somebody else's savings in a sack. It types a new deposit into the borrower's account, and that deposit is new money the borrower can spend.

That is the surprising idea at the center of this chapter. In this course's illustrative banking system, one café owner's 1,000-dollar deposit can support up to 10,000 dollars of deposits across many banks. A monetary base of 105 dollars can support a money supply of 1,050 dollars. You will see exactly how, and exactly why "up to" matters to you.

By the end of this chapter you will be able to:

name the three jobs money does and sort an everyday example into one of them;
tell money apart from wealth and from income;
describe M1, M2, and the monetary base, and say which one the central bank controls directly;
read a bank's ledger, splitting a deposit into required reserves and excess reserves;
trace a deposit through a chain of banks, one loan at a time;
compute the money multiplier 1 ÷ RR and use it to find the largest money supply a monetary base can support;
explain why 1 ÷ RR is a ceiling, not a forecast, and keep it apart from the spending multiplier.

Carry this line with you: banks keep the required part; they lend the excess.

Where we are

Already covered: Week 5, Aggregate Demand & Aggregate Supply, gave you the AD–AS diagram. Week 6, Business Cycles & Short-Run Fluctuations, read recessions and booms on it. Week 7, Fiscal Policy, taught the spending multiplier 1 ÷ (1 − MPC). Week 8, Midterm Review & Exam, added the flow-vs-stock habit.
This week: the first week of a new unit on money and the central bank: what money is, how it is measured, and how banks create it through a chain of deposits and loans.
How they connect: the money multiplier is the banking cousin of Week 7's spending multiplier, and Week 8's flow-vs-stock habit tells money (a stock) apart from income (a flow).
Where we're going next: Week 10, The Federal Reserve & Monetary Policy, starts the central bank's part of this unit. You will see who controls the monetary base, which tools move it, and how the money supply helps set an interest rate.

Two earlier ideas carry this chapter. From Week 7, the spending multiplier showed how one burst of spending becomes income for someone else, who spends part of it again, round after round. This week a deposit does something similar inside the banking system, and the chain has its own multiplier. From Week 8, a flow is an amount per period of time, like a monthly paycheck, while a stock is an amount at one moment, like the balance in your account right now. Money is a stock; income is a flow.

1. Name the three jobs money does

Picture a small town with no money at all. A baker wants a haircut. The barber wants eggs, not bread. The baker has to find a farmer who wants bread, trade for eggs, and then carry the eggs to the barber. That roundabout hunt is barter, and it wastes an afternoon.

Barter is trading goods or services directly for other goods or services with no money in between, which works only when each side wants what the other has.

Money ends the hunt. Here is the course's definition, and the three jobs it names.

Money is any asset that people generally accept in payment for goods, services, and debts; it does three jobs, serving as a medium of exchange, a store of value, and a unit of account.
A medium of exchange is the job money does when people hand it over to buy goods and services, which spares them the search for a trading partner who wants exactly what they have to offer.
A store of value is the job money does when it holds purchasing power over time, so that money earned now can still buy things later.
A unit of account is the job money does as the common measuring stick for prices, so that the costs of very different goods and services can be quoted in the same units and compared.

Worked example — sorting three moments. Name the job money is doing in each of these illustrative moments.

You pay a 2-dollar bus fare. You hand over money and get a ride. The driver does not need to want anything you own. That is a medium of exchange.
You save 300 dollars from a summer job and spend it on books in the fall. The money carried its buying power from summer to fall. That is a store of value.
You compare a 45-dollar phone plan with a 60-dollar one. Both prices are quoted in dollars, so you can line them up and see a gap of 60 − 45 = 15 dollars a month. That is a unit of account.

In words: the same dollar can do all three jobs, but in each moment one job is front and center.

Some courses add a fourth job, a standard of deferred payment, meaning money is the unit in which future debts are written. This course teaches three jobs and names the fourth only here.

Caveat: money is a good store of value, not a perfect one. Week 3 showed that inflation shrinks what a dollar buys, so money saved for years loses some of its value.

Misconception check. Students often think anything valuable counts as money. That is tempting, because gold, a gaming console, and a rare sneaker all have value. But the test is whether people generally accept it in payment. A cashier will not take your sneakers for groceries. An asset that cannot be handed over in everyday payment fails the medium-of-exchange job, so it is not money.

Memory hook: spend it, save it, price with it; one dollar, three jobs.

2. Separate money from wealth and income

An illustrative retired couple owns a house worth 300,000 dollars and keeps 400 dollars in cash in a kitchen drawer. People would call them wealthy. But at the grocery store, the house does them no good. Only the 400 dollars, or the balance in their checking account, can pay for the groceries.

Everyday speech blurs money, wealth, and income. Economics keeps them apart.

Wealth is everything a person or household owns minus everything it owes, at a point in time; a house or a car is part of wealth but is not money, because it cannot be handed over in payment.
Income is the earnings a person or household receives over a period of time, such as wages per week or per year; it is a flow, while the money a person holds is a stock.

The retired couple has a lot of wealth and very little money on hand. A new graduate might have a large income and almost no wealth yet. The words measure different things.

Worked example — sorting with the flow-vs-stock habit. An illustrative nurse earns 4,000 dollars a month, has 2,500 dollars in a checking account today, and owns a car. Sort each item.

4,000 dollars a month. It needs "a month" to make sense, so it is a flow. That is income.
2,500 dollars in checking today. It is measured at one moment, so it is a stock, and it can be spent directly. That is money.
The car. It is owned at one moment and counts toward wealth. It is not money, because a store will not accept it as payment.

In words: the paycheck is income, the checking balance is money, and the car is part of wealth.

Misconception check. Students often say "she makes a lot of money" when they mean "she earns a high income." That is tempting, because it is how people talk. But in this course money is a stock you hold, and income is a flow you earn. Asking "per month, or right now?" sorts them every time.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Think of something you own that has value but would be hard to use as payment. What would you have to do before you could spend that value?
(b) Think of a time a friend or relative said "money" when they meant income or wealth. Rewrite their sentence using the course's word.

Memory hook: money you hand over; wealth you own; income you earn per period.

3. Measure the money supply: M1, M2, and the monetary base

Suppose you could freeze the whole economy for one moment and count its money. What would you count? The cash in wallets, surely. The checking balances you can spend with a card, too. But what about a savings certificate that takes a few days to cash in? Economists answer by counting in layers, from the most spendable outward.

The money supply is the total amount of money in an economy at a point in time, measured with aggregates such as M1 and M2 and written M.
M1 is the narrow measure of the money supply: currency in the hands of the public plus the deposits people can spend most directly.
M2 is the broad measure of the money supply: everything in M1 plus near-money such as small time deposits and retail money market funds, which can be turned into spending money with little delay.

A note on the letter: in this course M always means the money supply. Imports are always written IM, as in Week 2.

There is one more layer, and it sits underneath both measures. Banks hold some cash in their vaults and keep accounts of their own at the central bank.

Bank reserves are the cash a bank holds in its vault plus the deposits it keeps at the central bank, money the bank has on hand rather than lent out.
The monetary base is currency plus bank reserves, the narrower total that the central bank controls directly and that the banking system builds the larger money supply on.

Think of the monetary base as the foundation of a building and M1 and M2 as the floors above it. The central bank pours the foundation. The banking system, through lending, builds the floors.

Worked example — placing the illustrative base. In this course's illustrative banking system (constructed for this course, not real data), the monetary base is 105 dollars.

Name the layer. The 105 dollars is currency plus bank reserves, so it is the monetary base, not the money supply.
Name who controls it. The central bank controls the monetary base directly.
Say what comes next. The banking system lends on top of it, so the money supply it supports will be larger than 105 dollars. Section 6 finds exactly how much larger.

In words: the 105 dollars is the foundation, and the money supply is the taller building the banks raise on it.

Misconception check. Students often use the monetary base and the money supply as if they were one number. That is tempting, because both are "how much money there is." But the monetary base is currency plus reserves, the part the central bank controls. The money supply adds all the deposits that bank lending creates on top of it. In the illustrative system the two are 105 dollars and, as you will see, 1,050 dollars.

Memory hook: the base is the foundation; M1 and M2 are the floors.

4. Read a bank's ledger: keep the required, lend the excess

A café owner closes up on a busy evening and deposits 1,000 dollars of cash takings at the first bank. What does the bank do with it? It does not lock all of it in the vault. It keeps a slice and lends out the rest. That is fractional-reserve banking.

Fractional-reserve banking is a banking system in which each bank keeps only a fraction of its deposits as reserves and lends out the rest, so the banking system as a whole can create money.
The required reserve ratio is the fraction of each deposit that rules require a bank to hold as reserves, written RR; in the course's illustrative banking system it is 0.10.
Required reserves are the part of a deposit a bank must keep on hand, equal to the required reserve ratio times the deposit; the bank keeps these and does not lend them.
Excess reserves are reserves a bank holds beyond what the rules require; in the classroom model a bank lends its excess reserves, and any excess it chooses to keep shrinks the chain of new deposits.

A bank's ledger has two sides. On one side are what the bank owes, such as your deposit. On the other side are what it holds, such as reserves and loans. The two sides always balance.

Worked example — the first bank's ledger. The café owner deposits 1,000 dollars, and RR = 0.10 (Dataset P, illustrative, constructed for this course, not real data).

Required reserves. 0.10 × 1,000 = 100 dollars. The bank keeps these.
Excess reserves. 1,000 − 100 = 900 dollars. These are the bank's to lend.
The loan. The bank lends the 900 dollars to a borrower.
Check the ledger. The bank owes the café owner 1,000 dollars. It holds 100 dollars in reserves plus a 900-dollar loan, and 100 + 900 = 1,000, so the two sides balance.

In words: the first bank keeps 100 dollars as required reserves and lends out the other 900.

The first bank's ledger after the café owner's deposit, in dollars (Dataset P, illustrative)
What the bank holds	Amount	What the bank owes	Amount
Required reserves	100	The café owner's deposit	1,000
Loan to a borrower	900
Total	1,000	Total	1,000

Misconception check. Students often say the bank lends out its required reserves. That is tempting, because "reserves" sounds like spare money waiting to be used. But required reserves are exactly the part the bank must keep. The bank lends the excess. Lending the required 100 gets the split backwards: the loan is 900, not 100.

Memory hook: banks keep the required part; they lend the excess.

5. Follow the loan: how banks create money one round at a time

The 900-dollar loan does not sit still. Say a bike-repair shop borrowed it to buy tools. The shop pays a tool supplier, and the supplier deposits the 900 dollars at a second bank. Now the second bank has a new deposit, and it does what the first bank did.

Worked example — three banks in a row. Keep RR = 0.10 and follow the money (Dataset P, illustrative).

Second bank. Required reserves are 0.10 × 900 = 90 dollars, and the loan is 900 − 90 = 810 dollars.
Third bank. The 810 dollars is spent and redeposited. Required reserves are 0.10 × 810 = 81 dollars, and the loan is 810 − 81 = 729 dollars.
The pattern. Each deposit is 900 ÷ 1,000 = 0.90 of the one before, because each bank keeps 0.10 and lends 0.90.
Deposits so far. After three banks, deposits total 1,000 + 900 + 810 = 2,710 dollars, and the 729-dollar loan is about to become a fourth deposit.

In words: one 1,000-dollar deposit has already become 2,710 dollars of deposits across three banks, and the chain is still running.

The deposit chain at RR = 0.10, first three banks, in dollars (Dataset P, illustrative)
Bank	New deposit	Required reserves kept	Loan made
First	1,000	100	900
Second	900	90	810
Third	810	81	729

Where did the extra money come from? The café owner still has a 1,000-dollar balance and can spend it. The tool supplier now has a 900-dollar balance and can spend that too. Both balances are money. The loan created a deposit that did not exist before, and no one's account went down to pay for it.

In practice (your tools). In Google Sheets, type 1000 in cell A1. In A2, type =A1*0.9 and copy it down to A30, so each row is 0.90 of the row above. In B1 type =A1*0.1 and copy it down beside each deposit to see the reserves each bank keeps. In C1 type =SUM(A1:A30) to add up the deposits. The rows shrink, and the total climbs toward 10,000 without ever passing it.

Misconception check. Students often think a bank can only lend money that savers already put in, so lending cannot create anything new. That is tempting, because it is true for one bank on its own. But when the loan is spent and redeposited, the system as a whole has more deposits than before. Each bank lends only what it has; the system creates money because the loans keep coming back as deposits.

Memory hook: each loan returns as a deposit; the chain keeps going.

6. Sum the chain with the money multiplier

Adding round after round by hand would take all evening. Fortunately, the chain has a shape. Each deposit is the same fraction, 0.90, of the one before it, so the whole chain adds up to a fixed total.

A geometric series is a sum in which each term is the same fraction of the term before it; the deposits created in a chain of bank loans form one, and it adds up to the first term divided by one minus that fraction.
The money multiplier is the number 1 ÷ RR, the most that one dollar of new reserves can become in deposits when every bank lends all of its excess reserves; it is an upper bound on money creation, not a forecast.

Worked example — summing the deposit chain. Use the café owner's deposit and RR = 0.10 (Dataset P, illustrative).

Sum the series. 1,000 ÷ (1 − 0.90) = 1,000 ÷ 0.10 = 10,000 dollars of deposits.
Use the shortcut. The money multiplier is 1 ÷ RR = 1 ÷ 0.10 = 10, so 1,000 × 10 = 10,000 dollars, the same ceiling.
Find the new money. 10,000 − 1,000 = 9,000 dollars of deposits the loans created.

In words: across the whole banking system, the 1,000-dollar deposit can support at most 10,000 dollars of deposits, and 9,000 dollars of that is new money created by lending.

The same multiplier works on the whole system. The money supply is the money multiplier times the monetary base: M = (1 ÷ RR) × monetary base.

Worked example — the money supply from the base. The illustrative monetary base is 105 dollars (Dataset B, illustrative, constructed for this course, not real data).

Multiplier at RR = 0.10. 1 ÷ 0.10 = 10.
Money supply. M = 10 × 105 = 1,050 dollars.

In words: a 105-dollar foundation supports at most a 1,050-dollar money supply when banks keep 10 percent of each deposit.

The reserve ratio sets the size of the multiplier. A lower ratio leaves more to lend each round, so the chain runs longer.

The money multiplier and the largest money supply a monetary base of 105 dollars supports at four required reserve ratios (Dataset B, illustrative)
Required reserve ratio RR	Money multiplier 1 ÷ RR	Money supply M (dollars)
0.05	1 ÷ 0.05 = 20	20 × 105 = 2,100
0.10	1 ÷ 0.10 = 10	10 × 105 = 1,050
0.20	1 ÷ 0.20 = 5	5 × 105 = 525
0.25	1 ÷ 0.25 = 4	4 × 105 = 420

Read the table from top to bottom. As the required reserve ratio rises, banks keep more and lend less, the multiplier shrinks, and so does the money supply.

In practice (your tools). In Google Sheets, type the four ratios 0.05, 0.10, 0.20, and 0.25 in A2 to A5. In B2 type =1/A2 for the multiplier and in C2 type =B2*105 for the money supply, then copy both down. Your sheet should match the table above row for row.

Now keep this multiplier apart from the one you met in Week 7. The spending multiplier, 1 ÷ (1 − MPC), scales a burst of spending into output, and it is a fiscal idea. The money multiplier, 1 ÷ RR, scales new reserves into deposits, and it is a banking idea. They look alike, because both sum a chain of rounds, but they answer different questions.

Misconception check. Students often grab the spending multiplier for a banking question, because both formulas start with "1 divided by." That is tempting, and Week 7's multiplier of 5 is fresh in memory. But using 5 on the café owner's deposit gives 5 × 1,000 = 5,000 dollars, half the correct ceiling of 10,000: 10,000 versus 5,000, a 2-fold miss. Ask what is being multiplied. Spending into output means 1 ÷ (1 − MPC); reserves into deposits means 1 ÷ RR.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) In your own words, explain to a friend why the deposit chain stops growing even though every bank keeps lending.
(b) In your own words, explain to a friend why the spending multiplier and the money multiplier both come from a chain of rounds, yet answer different questions.

Memory hook: one divided by the share kept; that is the most the chain grows.

7. Treat the money multiplier as a ceiling, not a forecast

Picture a kitchen faucet filling a sink through a hole in the bottom. The faucet sets how high the water could rise, but every leak keeps it lower. The money multiplier is the "could rise" number. Real banking has leaks.

The 10,000-dollar total from section 6 holds only if two things happen at every step. Every bank lends every excess dollar. And every borrower's spending lands back in a bank as a new deposit. Break either one, and the chain shrinks.

Some banks choose to keep extra reserves as a cushion instead of lending them.
Some people keep cash in a wallet or a drawer instead of depositing it, so that money leaves the chain.

Worked example — the ceiling with excess reserves. Suppose that in the illustrative system, banks choose to keep an extra 0.10 of each deposit on top of the required 0.10 (an illustrative assumption, constructed for this course).

Total share kept. 0.10 + 0.10 = 0.20.
New multiplier. 1 ÷ 0.20 = 5.
New ceiling on the money supply. 5 × 105 = 525 dollars.
Compare. 1,050 − 525 = 525 dollars less than the ceiling at RR = 0.10.

In words: when banks hold extra reserves, the same 105-dollar base supports at most 525 dollars of money, half the classroom ceiling.

Honesty note: the 10 percent ratio and the 1 ÷ RR multiplier are a classroom model of how deposits multiply, not a description of today's banks. In the United States, required reserve ratios have been zero since March 2020. Today the Federal Reserve runs an ample-reserves system, so lending is limited by banks' own reserve choices, capital rules, and the demand for loans, and real-world multipliers are far smaller than this classroom model.

An ample-reserves system is the way the Federal Reserve now runs monetary policy, with banks holding plenty of reserves and required reserve ratios set at zero, so the classroom money multiplier does not describe how much banks actually lend.

Why learn the model, then? Because its logic still holds. Banks create deposits when they lend, the base is smaller than the money supply, and anything that makes banks hold more reserves shrinks the expansion. The model teaches the mechanism; it does not forecast the number.

Misconception check. Students often read 1 ÷ RR as a prediction: "the money supply will be ten times the base." That is tempting, because the formula gives one tidy number. But the number is a ceiling, reached only if every bank lends every excess dollar and nobody holds cash. Extra reserves and cash in wallets keep the real expansion lower, so say "at most," never "will be."

Memory hook: the multiplier is a ceiling, not a forecast.

Key terms

barter — Trading goods or services directly for other goods or services with no money in between, which works only when each side wants what the other has. (first used: 1. Name the three jobs money does)
money — Any asset that people generally accept in payment for goods, services, and debts; it does three jobs, serving as a medium of exchange, a store of value, and a unit of account. (first used: 1. Name the three jobs money does)
medium of exchange — The job money does when people hand it over to buy goods and services, which spares them the search for a trading partner who wants exactly what they have to offer. (first used: 1. Name the three jobs money does)
store of value — The job money does when it holds purchasing power over time, so that money earned now can still buy things later. (first used: 1. Name the three jobs money does)
unit of account — The job money does as the common measuring stick for prices, so that the costs of very different goods and services can be quoted in the same units and compared. (first used: 1. Name the three jobs money does)
wealth — Everything a person or household owns minus everything it owes, at a point in time; a house or a car is part of wealth but is not money, because it cannot be handed over in payment. (first used: 2. Separate money from wealth and income)
income — The earnings a person or household receives over a period of time, such as wages per week or per year; it is a flow, while the money a person holds is a stock. (first used: 2. Separate money from wealth and income)
money supply — The total amount of money in an economy at a point in time, measured with aggregates such as M1 and M2 and written M. (first used: 3. Measure the money supply: M1, M2, and the monetary base)
M1 — The narrow measure of the money supply: currency in the hands of the public plus the deposits people can spend most directly. (first used: 3. Measure the money supply: M1, M2, and the monetary base)
M2 — The broad measure of the money supply: everything in M1 plus near-money such as small time deposits and retail money market funds, which can be turned into spending money with little delay. (first used: 3. Measure the money supply: M1, M2, and the monetary base)
bank reserves — The cash a bank holds in its vault plus the deposits it keeps at the central bank, money the bank has on hand rather than lent out. (first used: 3. Measure the money supply: M1, M2, and the monetary base)
monetary base — Currency plus bank reserves, the narrower total that the central bank controls directly and that the banking system builds the larger money supply on. (first used: 3. Measure the money supply: M1, M2, and the monetary base)
fractional-reserve banking — A banking system in which each bank keeps only a fraction of its deposits as reserves and lends out the rest, so the banking system as a whole can create money. (first used: 4. Read a bank's ledger: keep the required, lend the excess)
required reserve ratio — The fraction of each deposit that rules require a bank to hold as reserves, written RR; in the course's illustrative banking system it is 0.10. (first used: 4. Read a bank's ledger: keep the required, lend the excess)
required reserves — The part of a deposit a bank must keep on hand, equal to the required reserve ratio times the deposit; the bank keeps these and does not lend them. (first used: 4. Read a bank's ledger: keep the required, lend the excess)
excess reserves — Reserves a bank holds beyond what the rules require; in the classroom model a bank lends its excess reserves, and any excess it chooses to keep shrinks the chain of new deposits. (first used: 4. Read a bank's ledger: keep the required, lend the excess)
geometric series — A sum in which each term is the same fraction of the term before it; the deposits created in a chain of bank loans form one, and it adds up to the first term divided by one minus that fraction. (first used: 6. Sum the chain with the money multiplier)
money multiplier — The number 1 ÷ RR, the most that one dollar of new reserves can become in deposits when every bank lends all of its excess reserves; it is an upper bound on money creation, not a forecast. (first used: 6. Sum the chain with the money multiplier)
ample-reserves system — The way the Federal Reserve now runs monetary policy, with banks holding plenty of reserves and required reserve ratios set at zero, so the classroom money multiplier does not describe how much banks actually lend. (first used: 7. Treat the money multiplier as a ceiling, not a forecast)

Summary

Money does three jobs: medium of exchange, store of value, and unit of account.
Money is not wealth, and it is not income; income is a flow, money a stock.
M1 is the narrow money supply, M2 the broad one, and the monetary base is currency plus reserves.
The central bank controls the monetary base directly; bank lending builds the money supply on it.
A bank keeps its required reserves and lends its excess reserves.
Each loan is spent and redeposited, so the banking system creates new deposits.
The money multiplier is 1 divided by the required reserve ratio, and the money supply is at most that multiplier times the monetary base.
The money multiplier is a banking idea; the spending multiplier is a fiscal one.
The money multiplier is a ceiling, not a forecast: extra reserves and cash held outside banks shrink the expansion.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

Name the job money is doing in each illustrative moment: (a) a food truck lists its tacos at 4 dollars and its burritos at 9 dollars; (b) a grandparent keeps 200 dollars in a drawer for an emergency next winter; (c) a student pays for a used textbook with a phone payment.
An illustrative credit union in a mountain town (not real data) receives a new deposit of 2,500 dollars, and its required reserve ratio is 0.04. Find its required reserves and its loan, then the second bank's required reserves and loan once the loan is redeposited.
An illustrative island banking system (not real data) has a monetary base of 60 dollars and a required reserve ratio of 0.125. Find the money multiplier and the largest money supply the base can support. Then suppose banks choose to keep an extra 0.125 of each deposit; find the new ceiling.
A classmate is asked how much a new 300-dollar deposit can become across a banking system with RR = 0.08. They write 1 ÷ (1 − 0.08) and get about 1.09. Explain the error and give the correct ceiling.

Answers (worked reasoning — read after attempting)

(a) Unit of account: the prices are quoted in dollars, so the tacos and burritos can be compared, and the burrito costs 9 − 4 = 5 dollars more. (b) Store of value: the money carries buying power from now until next winter. (c) Medium of exchange: the payment is handed over in return for the book.
First bank: required reserves are 0.04 × 2,500 = 100 dollars, and the loan is 2,500 − 100 = 2,400 dollars. Second bank: the 2,400 dollars is redeposited, required reserves are 0.04 × 2,400 = 96 dollars, and the loan is 2,400 − 96 = 2,304 dollars. Each bank keeps the required part and lends the excess, so each loan is 0.96 of the deposit.
The money multiplier is 1 ÷ 0.125 = 8, so the largest money supply is 8 × 60 = 480 dollars. With the extra reserves, banks keep 0.125 + 0.125 = 0.25 of each deposit, the multiplier falls to 1 ÷ 0.25 = 4, and the ceiling falls to 4 × 60 = 240 dollars. Extra reserves cut the expansion in half.
The classmate used the shape of the spending multiplier, 1 ÷ (1 − MPC), and put the reserve ratio where the MPC belongs. The money multiplier is 1 ÷ RR = 1 ÷ 0.08 = 12.5, so the 300-dollar deposit can become at most 300 × 12.5 = 3,750 dollars of deposits. The 3,750 is a ceiling, not a forecast.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the central bank's tools and the money market model show who controls the monetary base and how the money supply sets an interest rate.

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