One cannot begin to understand how
money is created
and how it works without a good understanding of the banking system,
the special role of the central bank. This TRUE-FALSE quiz of 20
questions will test your understanding.
Drag the mouse pointer over the
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 monetary base is created by the Fed and is the
of the nation. It includes all base money held by the private
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
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
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
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
to replenish aggregate reserves lost to the withdrawal of cash by
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.
The required reserve ratio applies only to demand
deposits, not savings
accounts and term deposits which comprise the major part of a bank's
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
of the sellers' banks at the Fed which increases aggregate bank
Conversely, aggregate bank reserves decrease when the Fed sells
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
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
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
borrow the required reserves in the money market.
9. Complying with the reserve
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
In most cases, a bank's principal assets are its loans, some of which
10. Some countries do not impose a
requirement on their banks. [True*]
Unlike the U.S., several countries impose no reserve
Rather their central banks automatically cover bank overdrafts at a
above their target for the money market rate. They also pay
on bank reserves held at the central bank at a rate somewhat below the
11. The Fed does not control the
amount of bank
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
risk-weighted assets. By lending, a bank increases its
assets and thus reduces its margin against the capital ratio
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
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
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
requirements as long as its policy is to target the Fed funds rate.
14. Banks lend the money they
receive from their
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
assets. When banks lend they create new deposits without
existing deposits, and thereby increase the money supply. Conversely
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
capital is reduced by the amount of the loss. A bank with
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.
cannot offer checkable deposits, and their lending is done by writing
against deposits they hold in commercial banks.
17. When a bank issues a loan, its
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
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
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
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
Eurodollars are dollars in overseas banks that accept
Those deposits however are simply credits which eurobanks hold in US
Eurobanks may not create dollar-denominated deposits.
20. Most of the money used in the
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
between themselves through the transfer of reserves, which is done
on a net basis.