AP Macroeconomics: Fractional Reserve Banking and Money Creation (Money Multiplier = 1/Reserve Ratio)

AP Macroeconomics – Fractional Reserve Banking and Money Creation (Money Multiplier = 1/Reserve Ratio)

AP Macroeconomics – Study Guide
Topic: Fractional?Reserve Banking & Money Creation (Money Multiplier =?1?÷?Reserve Ratio)

What This Is

Fractional?reserve banking is the system in which banks keep only a fraction of deposits as cash (the reserve ratio) and lend out the rest. The amount of new money the banking system can create from an initial deposit is captured by the money multiplier (?MM?=?1?/?rr?). This concept is a staple on the AP Macro exam because it links the Federal Reserve’s policy tools, the money supply, and macro?economic outcomes such as inflation and output.

Real?world example: When the Fed lowers the reserve requirement from 10?% to 5?%, each $1,000 of deposits can support up to $20,000 of new loans, expanding the money supply and helping pull the economy out of a recession.

Key Terms & Formulas

• Reserve Ratio (rr) – The percentage of deposits that banks must hold as reserves (cash or deposits at the Fed).
• Money Multiplier (MM) – MM = 1?/?rr; shows how many dollars of money are created for each dollar of reserves.
• Excess Reserves – Reserves held above the required amount; available for new loans.
• Required Reserves – Minimum reserves banks must keep: RR = rr?×?Deposits.
• Deposit Expansion Process – The step?by?step cycle of a deposit, loan, re?deposit, and further lending that generates money.
• Money Supply (M1) – Currency + demand deposits + traveler's checks; the aggregate amount of money that the multiplier helps determine.
• Federal Reserve Discount Rate – The interest rate the Fed charges banks for borrowing reserves; a lower discount rate encourages banks to borrow more reserves and increase lending.
• Liquidity Preference Curve (Money Market) – Graph of interest rate (vertical) vs. quantity of money demanded (horizontal); the supply curve is vertical at the Fed?set money supply.
• Reserve Requirement Change (Policy Shift) – A leftward shift of the money supply curve when the reserve ratio rises; a rightward shift when it falls.
• Bank Run – A sudden, massive withdrawal of deposits that can force banks to liquidate assets; illustrates why a fractional system needs a lender?of?last?resort (the Fed).

Step?by?Step / Process Flow (Solving a Typical AP Problem)

1. Read the prompt – Identify the initial deposit amount, the reserve ratio, and whether the Fed changes the ratio or the discount rate.
2. Calculate the money multiplier – Use MM = 1?/?rr (e.g., rr?=?0.08-MM?=?12.5).
3. Determine the maximum potential money creation – Multiply the initial deposit by the multiplier (Deposit?×?MM).
4. Draw the Money?Market diagram –
5. Vertical axis: Interest rate (i).
6. Horizontal axis: Quantity of money (M).
7. Plot the money supply (vertical line) at the level you just computed.
8. Show the liquidity?preference (downward?sloping) curve; the intersection gives the equilibrium interest rate.
9. Explain the macro impact – Connect the new equilibrium interest rate to AD?AS: lower i-cheaper borrowing-AD shifts right-higher real GDP and possibly higher price level.
10. Answer the FRQ – State the mechanism (reserve requirement-multiplier-money supply-interest rate-aggregate demand) and note any assumptions (e.g., banks loan out all excess reserves, no cash leakages).

Common Mistakes

AP Exam Insights

1. Multiple?Choice Focus:
2. Questions often give a reserve ratio and ask for the resulting money multiplier or the change in the money supply after a policy shift.

3. Look for answer choices that correctly invert the reserve ratio (e.g., rr?=?0.05-MM?=?20).

4. Free?Response Emphasis:

5. FRQs may ask you to draw the money?market diagram, label the supply line, and explain how a change in the reserve requirement affects the equilibrium interest rate and AD.

6. You must state the chain of causality (reserve ratio-multiplier-money supply-interest rate-AD).

7. Tricky Distinctions:

8. Reserve requirement vs. discount rate – Both are Fed tools, but only the reserve requirement directly changes the multiplier.

9. Money creation vs. money creation “in the short run.” – The multiplier assumes full loan?out of excess reserves; the exam may ask you to note the assumption.

10. Graphing Requirements:

11. Always label axes (i on vertical, M on horizontal).
12. Show the vertical money?supply line before and after the policy change.
13. Indicate the new equilibrium interest rate with a point and label it.

Quick Check Questions

1. MCQ: The Fed lowers the reserve requirement from 12?% to 6?%. What is the change in the money multiplier?
2. Answer: It doubles from 8.33 to 16.7.

3. Why: MM?=?1?/?rr; 1/0.12?8.33-1/0.06?16.7.

4. FRQ?style: A bank receives a $5,000 deposit. The reserve ratio is 10?%. Assuming banks loan out all excess reserves, calculate the maximum increase in the money supply.

5. Answer: $45,000.

6. Why: MM?=?1/0.10?=?10; $5,000?×?10?=?$50,000 total money, but $5,000 is the original deposit, so net increase = $45,000.

7. MCQ: Which of the following would decrease the money multiplier?
   A) Lowering the reserve ratio.
   B) Raising the reserve ratio.
   C) Increasing the discount rate.
   D) Reducing excess reserves.

8. Answer: B) Raising the reserve ratio.
9. Why: A higher rr makes 1?/?rr smaller, shrinking the multiplier.

Last?Minute Cram Sheet (10 One?Liners)

1. Money Multiplier (MM) = 1?÷?Reserve Ratio (rr).
2. Reserve Requirement (RR) = rr?×?Deposits.
3. Higher rr-lower MM-smaller potential money supply.
4. Money?Market graph: i (vertical) vs. M (horizontal); money supply is a vertical line.
5. Lower reserve ratio-rightward shift of the money?supply line-lower equilibrium interest rate.
6. Excess reserves = Total reserves – Required reserves; only excess can be loaned out.
7. Discount rate cut-banks borrow more reserves-can increase lending (indirectly raises money supply).
8. Currency drain (people holding cash) reduces the effective multiplier because cash is not redeposited.
9. “Supply increases” in the money market means the vertical supply line moves right, not up.
10. Assumption for the textbook multiplier: banks loan out 100?% of excess reserves and borrowers redeposit all loan proceeds.

Good luck – you’ve got the tools; now apply them on the exam!