5 Steps to a 5 AP Macroeconomics 2019

148 ❯ Step 4. Review the Knowledge You Need to Score High

How does this work?

If the original price of the bond is $100, promising to pay $10 in interest, the interest rate

is 10 percent. If the price falls to $90, the same $10 of interest now yields $10/$90 = 11.1

percent. Higher interest rates on bonds increase the opportunity cost of holding cash, and

so the quantity of money demanded falls until the interest rate rises to the point where

MD = $500. This adjustment is seen in Figure 11.4.

MS

MD

Money

Nominal

Interest

Rate, i %

$1,000

10%

$500

MS’

Shortage

of Money

Figure 11.4

TIP

•   Increasing the money supply lowers interest rates as surplus money moves into the

bond market, increasing bond prices.

•   Decreasing the money supply increases interest rates as a shortage of money creates a

sell-off of bonds, decreasing bond prices.

11.2 Fractional Reserve Banking and Money Creation

Main Topics: Fractional Reserve Banking, Money Creation, The Money Multiplier

If you asked 10 bank tellers in your hometown, “Do you create money here?” I’m guessing

that 9 or 10 of them would reply, “No way.” They’re wrong. The fractional reserve system

of banking, plus the bank’s profit motive, creates money and opens the door for the Fed to

promote or inhibit such money creation.

Fractional Reserve Banking

Fractional reserve banking is a system in which only a fraction of the total money supply

is held in reserve as currency. The short story that follows illustrates how fractional reserve

banking might have evolved.

Eli’s Community Bank (ECB) opens its doors and is now accepting deposits from

citizens who want a safe place to put their money. Eli promises to always keep 100 percent

of their money on hand so that if a person needs to buy groceries, he or she can simply

withdraw some money and take it to the store.

One day, a citizen comes up to the bank asking to borrow some money to start a lemon-

ade stand, but Eli has to turn her down because if any of his customers comes to withdraw

money for groceries and finds that it was not in the vault, they would be extremely irritated.

After a month or so, Eli observes that on any given day, there are very few withdrawals and

most of the time the deposited money just sits there in the vault, doing nothing.

KEY IDEA