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A Banking Test

Mortgage and Lending with Mount Olympus Mortgage

One cannot begin to understand how money is created and how it works without a good understanding of the banking system, and the special role of the central bank.  This TRUE-FALSE quiz of 20 questions will test your understanding.

Drag the mouse pointer over the bracket to see the answer.

1. The Fed creates the monetary base of the U.S. in the form of Federal Reserve notes and bank reserves on deposit at the Fed.  [True*]

The monetary base is created by the Fed and is the definitive money of the nation.  It includes all base money held by the private sector, but not that held by the government or foreign central banks.

2. Banks create monetary base money when they issue loans.  [False]

Banks cannot create base money.  A borrower receives a credit in the form of a deposit which he can withdraw as cash, i.e. base money, on demand.  Conversely a cash deposit into a bank converts the money into a credit, which in effect is a loan to the bank.

3. A bank's reserves consist of its vault cash and its deposits at the Fed.  [True*]

Those are the official reserves of a bank.  Banks also hold Treasury bills as secondary reserves.  Even with no minimum reserve requirement, a bank must still be able to provide cash to its depositors on demand, and to cover their checks as they are cleared at the Fed.

4. The central bank controls the size of the monetary base.  [False]

The amount of cash in circulation depends only on how much the public chooses to hold in lieu of bank deposits.  If the central bank failed to replenish aggregate reserves lost to the withdrawal of cash by depositors, it would imperil the liquidity of the banking system.

5. A bank is required to hold reserves at least equal to a prescribed fraction of its total deposit liabilities.  [False]

The required reserve ratio applies only to demand deposits, not savings accounts and term deposits which comprise the major part of a bank's deposit liabilities.

6. The Fed can increase the total of bank reserves by purchasing Treasury securities from the public. [True*]

When the Fed purchases Treasury securities, it credits the accounts of the sellers' banks at the Fed which increases aggregate bank reserves.  Conversely, aggregate bank reserves decrease when the Fed sells Treasury securities from its own portfolio.

7. A bank loses reserves whenever it pays out cash or transfers funds by wire for its depositors.  [True*]

Both of these transactions reduce a bank's official reserves.  A bank gains reserves when it receives a check written on another bank, or when a customer deposits cash in his account.

8. When a bank's reserves are just sufficient to meet the required reserves against demand deposits, it must wait for additional deposits before it can continue lending.  [False]

A bank in good standing can always borrow the funds it needs to meet its reserve requirements.  Large banks often lend first and, if needed, borrow the required reserves in the money market.

9. Complying with the reserve requirement guarantees a bank's solvency.  [False]

A bank can have ample reserves and still be insolvent if its other assets together with its reserves are not sufficient to cover its liabilities.  In most cases, a bank's principal assets are its loans, some of which may be uncollectable.

10. Some countries do not impose a minimum reserve requirement on their banks.  [True*]

Unlike the U.S., several countries impose no reserve requirement.  Rather their central banks automatically cover bank overdrafts at a penalty above their target for the money market rate.  They also pay interest on bank reserves held at the central bank at a rate somewhat below the target rate.

11. The Fed does not control the amount of bank lending.  [True*]

The amount a bank may lend is limited only by the capital adequacy rule which requires that its capital be at least a prescribed fraction of its risk-weighted assets.  By lending, a bank increases its risk-weighted assets and thus reduces its margin against the capital ratio requirement.

12. The Fed funds rate is the interest rate the Fed charges banks to borrow from its discount window.  [False]

The Fed funds rate is a market interest rate that one bank charges another for the temporary use of its unneeded funds on deposit at the Fed.  A bank can also borrow from the Fed at its discount rate, which is one percentage point higher than the target Fed funds rate.

13. As aggregate bank lending increases, the Fed must increase banking system reserves in order to maintain control of the Fed funds rate.  [True*]

When banks increase aggregate lending, that creates a demand for Fed funds to meet reserve requirements.  The Fed has no choice but to supply the reserves that banks need in the aggregate to meet their reserve requirements as long as its policy is to target the Fed funds rate.

14. Banks lend the money they receive from their depositors.  [False]

A deposit received by a bank becomes a part of its reserves, which it may hold to back increased lending, or it may use to purchase other interest-earning assets.  When banks lend they create new deposits without affecting existing deposits, and thereby increase the money supply. Conversely when bank loans are paid off, the money supply decreases.

15. A bank's own money is at risk when it issues a loan.  [True*]

Like other financial intermediaries, banks place their own capital at risk through lending.  If a bank cannot collect on the loan, its own capital is reduced by the amount of the loss.  A bank with inadequate capital will be placed under supervision or closed by its regulator.

16. Non-bank financial institutions cannot accept demand deposits.  [True*]

Non-banks such as investment banks, brokerage dealers, and finance companies, depend on commercial banks to execute their money transactions.  They cannot offer checkable deposits, and their lending is done by writing checks against deposits they hold in commercial banks.

17. When a bank issues a loan, its liabilities and reserves increase by the amount of the loan.  [False]

Lending increases a bank's assets and liabilities but not its reserves.  The additional deposit liability created by the loan reduces its reserve ratio.  If the ratio falls below the requirement, it must increase its reserves which it can do by borrowing funds in the money market.

18. The use of credit cards increases the M1 money supply.  [True*]

Using a credit card is the electronic equivalent of going to your bank, obtaining a loan, and using the deposit to write a check for the purchase.  The seller receives a deposit in his own bank, which adds to the total of M1 -- until the buyer pays off the loan.

19. Eurodollars are U.S. dollars issued by a European bank.  [False]

Eurodollars are dollars in overseas banks that accept dollar denominated-deposits.  Those deposits however are simply credits which eurobanks hold in US banks.  Eurobanks may not create dollar-denominated deposits.

20. Most of the money used in the private sector is bank credit money rather than monetary base money.  [True*]

The private sector operates mainly on bank credit, involving the transfer of bank deposits from payer to payee.  However banks must settle accounts between themselves through the transfer of reserves, which is done daily on a net basis.