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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.

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