Here's a trick question: when you deposit $1,000 of cash at a bank, how much money exists? Still $1,000 — your cash became a checking balance. But now the bank lends $900 of it to a landscaper, who deposits it at her bank, which lends $810 to a caterer… Your $1,000 is now backing thousands of dollars of checking balances that people are actively spending. Banks create money — not by printing, but by lending — and the whole system runs on a shared confidence that we won't all show up for our cash at once. This lesson explains what money is, who counts it, and exactly how much of it a banking system can conjure from one deposit.
Money is whatever is generally accepted in exchange. Its three functions:
Commodity money has intrinsic value (gold, cigarettes in POW camps). Fiat money — all modern currency — has value only because government declares it legal tender and, more deeply, because everyone accepts it. No gold backs the dollar; acceptance does.
Liquidity = how quickly and cheaply an asset converts to spendable form. The aggregates are nested by liquidity:
| Aggregate | Contents |
|---|---|
| M0 (monetary base) | Currency in circulation + bank reserves |
| M1 | Currency in circulation + checkable (demand) deposits + savings deposits (included since the 2020 redefinition) |
| M2 | M1 + small time deposits (CDs) + money market funds |
Not money at all: stocks, bonds, credit cards (a credit card is a loan trigger, not money), gold jewelry, real estate. Currency inside bank vaults is not "in circulation" — deposits move money between categories, not into existence.
Banks keep only a fraction of deposits as reserves (vault cash + deposits at the Fed) and lend the rest:
A simple T-account after a $1,000 deposit with rr = 10%:
Assets | Liabilities
Required reserves $100 | Checkable deposits $1,000
Excess reserves $900 |
The single bank can lend only its excess reserves ($900) — never a multiple.
The system multiplies. Loans get spent, redeposited, re-lent — each round smaller by the reserve fraction:
Money multiplier = 1/rr
With rr = 10%: multiplier = 10. From a $1,000 new deposit: - Maximum total checkable deposits: 1,000 × 10 = $10,000 - Maximum new money created by lending: $9,000 (the original $1,000 was already money)
Two starting points, two answers (the exam's favorite trap): - Cash deposit: at the moment of deposit, M1 is unchanged (currency ↓, deposits ↑). New money = multiplier × deposit − deposit. - Fed buys a bond from the public / injects reserves: the entire multiplier applies to new money — the injection wasn't previously counted in M1.
The multiplier is a maximum: it shrinks if banks hold excess reserves or the public holds cash out of the system. (And in the modern ample-reserves world, the requirement is effectively zero and the Fed steers by interest on reserves — Lesson 10. The AP still tests the classic mechanics; know both.)
Apply It: rr = 25%. The Fed injects $400 of new reserves into the banking system. Maximum change in the money supply? → multiplier = 4; ΔMS = 4 × 400 = $1,600 (full multiplier — reserves injection, not a cash re-classification).
The Fed is the U.S. central bank: it conducts monetary policy (Lesson 10), supervises banks, acts as lender of last resort, clears payments, and serves as the government's bank. It is not Congress (fiscal), and it does not print value into existence — it manages reserves and interest rates. Its policy body is the FOMC (Federal Open Market Committee).
No new curve — a schematic the exam expects you to reason through:
[GRAPH/SCHEMATIC: The deposit-expansion chain (rr = 10%)
Round 1: $1,000 deposited at Bank A → $100 required reserve, $900 lent
Round 2: $900 deposited at Bank B → $90 reserved, $810 lent
Round 3: $810 deposited at Bank C → $81 reserved, $729 lent
… each round = 90% of the last
Sum of all deposits: 1,000 × (1/0.10) = $10,000 total; $9,000 newly created
Reading: one bank lends its excess; the SYSTEM multiplies]
AP requirements: be ready to fill a T-account (required vs. excess reserves), compute a single bank's maximum loan, and separately compute the system-wide maximum — three different numbers from one deposit. Label which question you're answering; mixing them is the #1 Unit 4 calculation error. The money market graph arrives next lesson.
1. A. Comparing prices uses money as the measuring stick — unit of account. B: no transaction occurred. C: no holding over time. D/E: not functions of money.
Fix: Buying = medium of exchange; comparing = unit of account; holding = store of value.
2. C. Fiat = valuable by decree + acceptance, unbacked by commodities. A: gold convertibility ended decades ago. B: paper's intrinsic value is nil. D: no such backing rule. E: inflation erodes fiat money constantly.
Fix: Fiat money's only backing is collective acceptance — that's the definition.
3. E. M1's core: currency in circulation + checkable deposits. A: CDs sit in M2. B/D: securities aren't money. C: credit limits are borrowing capacity, not money.
Fix: If you can spend it directly today, it's M1; if it must be converted or borrowed, it isn't.
4. D. Currency (spendable now) → checking (card/check) → CD (early-withdrawal penalty) → house (months to sell). A: exactly reversed. B/C/E: scrambled orders.
Fix: Rank by how fast the asset becomes spendable cash without loss.
5. B. Required = 0.20 × 50,000 = 10,000; excess = 14,000 − 10,000 = $4,000. A: that's required reserves. C: total reserves. D: deposits minus reserves. E: percentage confusion.
Fix: Excess = actual reserves − (rr × deposits); compute required first.
6. A. A single bank lends its excess reserves only: $4,000. B: can't lend required reserves. C: that's the required amount. D/E: system-level or deposit-level numbers.
Fix: One bank = excess reserves; only the system multiplies.
7. D. 1/0.125 = 8. A: quoted the percentage. B/C: inversion errors. E: decimal slip.
Fix: Money multiplier = 1/rr; convert the percent to a decimal first.
8. E. Reserve injections get the full multiplier: 10 × 10M = $100M. A: ignores the multiplier. B/D: applies the cash-deposit haircut, but a Fed purchase adds money that wasn't in M1 before. C: that's the required-reserve slice.
Fix: Fed injection → full multiplier × amount; cash redeposit → multiplier × amount − the original deposit.
9. C. Currency ↓ $5,000, deposits ↑ $5,000: composition change, M1 flat. A/D: growth comes later, through lending. B: nothing was destroyed. E: reserve math doesn't apply at the instant of deposit.
Fix: Moving money between pockets (cash ↔ checking) never changes M1 by itself.
10. B. Idle excess reserves break the lending chain — the realized multiplier shrinks. A/C: those keep the chain at maximum. D: a lower rr raises the ceiling. E: irrelevant plumbing.
Fix: The two leaks that shrink the multiplier: banks hoarding excess reserves, public holding cash.
11. D. In a panic, the Fed lends reserves to solvent-but-illiquid banks so withdrawals don't collapse them. A: the Fed doesn't bank households. B: that's the FDIC. C: the Fed isn't the Treasury's automatic financier. E: private rates are market-set.
Fix: Lender of last resort = emergency reserves for banks, stopping runs.
12. A. Total deposits: 4 × 8,000 = 32,000; NEW money = 32,000 − 8,000 = $24,000 (the cash was money already). B: forgets to subtract the original deposit. C: no multiplication. D: that's the required reserve on the deposit. E: that's the first-round loan.
Fix: New money from a cash deposit = (1/rr) × deposit − deposit.
13. C. Central bank ↔ money/interest rates; Congress & president ↔ taxes/spending. A: swapped. B: the Treasury conducts neither. D: swapped tools. E: they're distinct institutions and instruments.
Fix: Ask who acts — Fed = monetary, Congress = fiscal — before touching any policy question.
The banking system of Alvor has a reserve requirement of 20%. Banks hold no excess reserves and the public redeposits all funds. Mira deposits $10,000 in currency into her checking account at Banco Prime.
(a) Calculate the money multiplier for Alvor. Show your work.
(b) For Banco Prime alone, calculate (i) the addition to required reserves and (ii) the maximum new loan it can make from Mira's deposit.
(c) Calculate the maximum increase in total checkable deposits for the banking system as a whole (including Mira's deposit).
(d) Calculate the maximum increase in the MONEY SUPPLY resulting from Mira's deposit. Explain why this differs from your answer in (c).
(e) If banks in Alvor decided to hold some excess reserves, would the actual money creation be larger than, smaller than, or equal to your answer in (d)? Explain briefly.
1. A. Comparing prices uses money as the measuring stick — unit of account. B: no transaction occurred. C: no holding over time. D/E: not functions of money. Fix: Buying = medium of exchange; comparing = unit of account; holding = store of value.
2. C. Fiat = valuable by decree + acceptance, unbacked by commodities. A: gold convertibility ended decades ago. B: paper's intrinsic value is nil. D: no such backing rule. E: inflation erodes fiat money constantly. Fix: Fiat money's only backing is collective acceptance — that's the definition.
3. E. M1's core: currency in circulation + checkable deposits. A: CDs sit in M2. B/D: securities aren't money. C: credit limits are borrowing capacity, not money. Fix: If you can spend it directly today, it's M1; if it must be converted or borrowed, it isn't.
4. D. Currency (spendable now) → checking (card/check) → CD (early-withdrawal penalty) → house (months to sell). A: exactly reversed. B/C/E: scrambled orders. Fix: Rank by how fast the asset becomes spendable cash without loss.
5. B. Required = 0.20 × 50,000 = 10,000; excess = 14,000 − 10,000 = $4,000. A: that's required reserves. C: total reserves. D: deposits minus reserves. E: percentage confusion. Fix: Excess = actual reserves − (rr × deposits); compute required first.
6. A. A single bank lends its excess reserves only: $4,000. B: can't lend required reserves. C: that's the required amount. D/E: system-level or deposit-level numbers. Fix: One bank = excess reserves; only the system multiplies.
7. D. 1/0.125 = 8. A: quoted the percentage. B/C: inversion errors. E: decimal slip. Fix: Money multiplier = 1/rr; convert the percent to a decimal first.
8. E. Reserve injections get the full multiplier: 10 × 10M = $100M. A: ignores the multiplier. B/D: applies the cash-deposit haircut, but a Fed purchase adds money that wasn't in M1 before. C: that's the required-reserve slice. Fix: Fed injection → full multiplier × amount; cash redeposit → multiplier × amount − the original deposit.
9. C. Currency ↓ $5,000, deposits ↑ $5,000: composition change, M1 flat. A/D: growth comes later, through lending. B: nothing was destroyed. E: reserve math doesn't apply at the instant of deposit. Fix: Moving money between pockets (cash ↔ checking) never changes M1 by itself.
10. B. Idle excess reserves break the lending chain — the realized multiplier shrinks. A/C: those keep the chain at maximum. D: a lower rr raises the ceiling. E: irrelevant plumbing. Fix: The two leaks that shrink the multiplier: banks hoarding excess reserves, public holding cash.
11. D. In a panic, the Fed lends reserves to solvent-but-illiquid banks so withdrawals don't collapse them. A: the Fed doesn't bank households. B: that's the FDIC. C: the Fed isn't the Treasury's automatic financier. E: private rates are market-set. Fix: Lender of last resort = emergency reserves for banks, stopping runs.
12. A. Total deposits: 4 × 8,000 = 32,000; NEW money = 32,000 − 8,000 = $24,000 (the cash was money already). B: forgets to subtract the original deposit. C: no multiplication. D: that's the required reserve on the deposit. E: that's the first-round loan. Fix: New money from a cash deposit = (1/rr) × deposit − deposit.
13. C. Central bank ↔ money/interest rates; Congress & president ↔ taxes/spending. A: swapped. B: the Treasury conducts neither. D: swapped tools. E: they're distinct institutions and instruments. Fix: Ask who acts — Fed = monetary, Congress = fiscal — before touching any policy question.
Exam tip: Unit 4 calculations reward labeling your target before computing: (1) single-bank loan = excess reserves; (2) total deposits = multiplier × deposit; (3) new money = total − original (cash deposit) or the full product (Fed injection). Write which of the three you're finding; the arithmetic is trivial once the target is named. Next lesson: the Fed actually pulls the levers — monetary policy and the money market graph.