5 Steps to a 5 AP Macroeconomics 2019

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

Step 3. Theo uses his $900 at Tractor Supply, which has a checking account with ECB.

Checking deposits have now increased by $900, and this is new money. ECB must keep

$90 as required reserves, and excess reserves now total $810.

Balance Sheet ECB (Step 3)

ASSETS LIABILITIES

Required Reserves $ 1, 190 Checking Deposits $1,900

Excess Reserves $ 1, 810

Loans $ 1, 900

Total Assets $ 1,900 Total Liabilities $1,900

Balance Sheet ECB (Step 4)

ASSETS LIABILITIES

Required Reserves $ 271 Checking Deposits $2,710

Excess Reserves $ 729

Loans $ 1,710

Total Assets $ 2,710 Total Liabilities $2,710

Step 4. ECB makes an $810 loan to Max, who wants to buy some furniture. Max spends

$810 at Furniture Factory, which also banks with ECB, increasing checking deposits by

$810. ECB must keep $81 in required reserves, leaving $729 in excess reserves.

The Money Multiplier

An initial deposit of $1,000 creates, after only two loans are made and redeposited, $2,710

of checking deposits. This process could continue until there are no more excess reserves

to be loaned, ultimately creating $10,000 of deposits. Of this $10,000 of deposits, $1,000

was already in the money supply (cash under Katie’s mattress) but $9,000 has been created

as new money, seemingly out of thin air. This process is known as the money multiplier,

which measures the maximum amount of new checking deposits that can be created by

a single dollar of excess reserves. The idea of the money multiplier, not to mention the

mathematics, is identical to our coverage of the spending multiplier.

M = 1/(Reserve requirement) = 1/rr (= 1/.10 = 10 in our example)

We had $900 in initial excess reserves and this would have multiplied into a maximum

of $9,000 if (a) at every stage the banks kept only the required dollars in reserve, (b) at every

stage borrowers redeposit funds into the bank and keep none as cash, and (c) borrowers are

willing to take out excess reserves as loans.

KEY IDEA

•   The maximum, or simple, money multiplier M = 1/rr.

•   An initial amount of excess reserves multiplies by, at most, a factor of M.

TIP