Problem :
What is the major service provided by banks?
The primary role that banks serve is that of financial intermediary. Banks
bring together savers and borrowers and make the financial markets work.
Problem :
What happens when you deposit money in a bank?
First, the money is recorded (usually by computer) and added to your account.
It is then placed into the vault. At various times during the day, money is
removed from the vault and taken to a second bank. This bank, unlike the first,
does not serve individuals. It is a "banks' bank," usually a branch of the
Federal Reserve. The first bank is able to make deposits, withdrawals, and
take out loans from the second bank.
Problem :
How do banks earn money?
As financial intermediaries, banks earn enough to support their activities by
the difference between the interest rate paid to savers and the interest
rate charged on loans. When customers make deposits in a savings account, they
earn interest on the principle. Similarly, when customers take out
loans, they pay interest on the principle. By charging the borrower a slightly
higher interest rate than that which is given to the depositor, a bank is able
to cover its expenses. Finally, banks invest money in low risk stocks and bonds
to increase its value.
Problem :
Explain the advantage of fractional reserve banking.
In the real world though, banks are required to hold significantly less than
100% of the deposits in reserve. A bank can make loans, which are then
redeposited, and can then be loaned out again; this, in essence, creates money.
In this way, any banking system with less than 100% required reserves
effectively increases the money supply. This system is called fractional
reserve banking because banks hold less than 100% or a fraction of the
deposits in reserve.
Problem :
What is the change in the money supply created by an initial deposit of $2000 if
the reserve requirement is 20%?
First multiply the initial deposit by one over the reserve rate. This gives
$2000 * (1 / .2) = $10,000. Then, subtract the initial deposit: $10,000 - $2000
= $8000. Thus, a $2000 deposit yields an $8000 change in the money supply.
