ap economics: module 25 terms

currency in circulation

currency in circulation

bills + coins (cash)

• makes up over 40% of M1

• makes up over 90% of the monetary base

t or f: deposits make up a lot of the M2 supply

t

bank reserves

currency that banks hold in their vaults and their deposits at the FED

• not currency in circulation

• money that banks can’t loan out

T-account

summarizes a business’s financial position by showing, in a table, their assets (left column) and liabilities (right column)

owner’s equity

amount of assets - amount of liabilities

• represents the owner’s financial investment into the business

t or f: banks are able to have less assets than liabilities

f: they are legally required to hold more assets than liabilities

reserve ratio

fraction of deposits that a bank holds as reserves

required reserve ratio

the smallest fraction of deposits that the FED requires banks to hold

why do most of depositor’s funds turn into loans for investors?

loans collect interest —> profit for the bank

• HOWEVER: loans are illiquid, and if depositors’ demands are larger than the bank’s reserves, converting loans means that the bank must sell them for cheaper —> bank failure

bank run

a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure

• causes chain reaction of bank runs on more banks (govt. has set regulations to mitigate this impact)

main features of a system designed to mitigate the effects of bank runs

• deposit insurance

• capital requirements

• reserve requirements

• discount window

deposit insurance

guarantees that depositors will be paid back their deposits even if the bank can’t

• get their funds from the FDIC

• elimates the main cause of bank runs —> people are assured their money is safe

how can deposit insurance cause incentive issues?

when people are guaranteed to get their money back, they don’t focus as much on the success and actions of banks. this gives bank owners the incentive to participate in sketchy/risky behavior.

• this risky behavior will have no major consequences (if it works, the bank makes profit; if it doesn’t the bank will still be backed by the FDIC)

• to prevent this, the required reserve ratio was implemented

bank’s capital

excess of assets over deposits and liabilities

• usually required to be at least 7% of the bank’s assets

reserve requirements

rules set by the FED that determine the required reserve ratio for banks

• between 0-10% in the U.S.

the discount window

channel for the FED to send banks $ when needed

• helps banks avoid having to sell their loans for cheaper to fulfill depositors’ demands

2 ways banks impact money supply

1. removes currency from circulation

2. creates money

how do banks create money?

accepts deposits and makes loans —> increases money supply past just currency in circulation

how may banks decrease the money supply?

• having loans be repaid

• putting money in vaults (lower cic)

t or f: leaks out of the banking system increase the money multiplier (MM)

f: leaks out of the system occur when people hold their money, and this decreases the MM (less money in circulation —> less effect it can have)

excess reserves

bank’s resources over/above its required resources

money multiplier

ratio of the money supply to the monetary base

• the factor by which we multiply an initial change in excess reserves to find the total resulting change in checkable bank deposits

• indicates total number of dollars created in the banking system by each $1 addition to the monetary base

• 1/rr (rr = reserve ratio)

• usually around 1.9

monetary base

currency in circulation + bank resources

2 ways in which the monetary base is different from the money supply

1. bank reserves are part of the monetary base, but not the money supply

2. checkable bank deposits are not part of the base, but are part of the money supply