ECON 201 1st Edition Lecture 21Outline of Last Lecture I. Money and Its Functions in an Economya. Definition of moneyb. Definition of medium of exchangec. Definition of unit of accountd. Definition of store of valuee. Definition of standard of deferred paymentII. Types of Moneya. Definition of commodity moneyb. Definition of representative commodity moneyc. Definition of fiat moneyIII. The Money Supplya. Definition of money supply/money stockb. Definition of currencyc. Definition of demand deposits/checkable depositsd. Definition of M1e. Definition of M2IV. The Banking Systema. Definition of fractional reserve banking systemb. Definition of reserve requirementsc. Definition of reserve ratio/ROutline of Current Lecture I. Bank Reservesa. Definition of required reservesb. Definition of actual reservesc. Definition of excess reservesII. T-Account and Examplesa. Definition of t-accountIII. Money Multipliera. Definition of money multiplierIV. Extended Bank Balance Sheeta. Definition of bank capital These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.b. Definition of leveragec. Definition of leverage ratioCurrent LectureI. Bank ReservesThere are three types of reserves in a bank: required reserves, actual reserves, and excess reserves. Required reserves are the amount of reserves the bank must hold; actual reserves arethe amount of reserves that banks really hold, and excess reserves are the amount beyond what the bank must hold. The formula for these three reserves is actual reserves = required reserves + excess reserves. The key to making money in a banking system is to have excess reserves to be able to lend money to borrowers and make a profit from the interest. The following image shows a cycle of the fractional reserve banking system and displays how banks make a profit. II. T-Account and ExamplesA T-account is a simplified accounting statement that shows a bank’s assets and its liabilities. It is called a T-account because it is shaped like a T. An example T-account of First National Bank’s assets and liabilities is shown below. First National Bank – Statement 1Assets LiabilitiesReserves: $1,000 Deposits: $1,000Loans: $0Using the example above, suppose that the required reserve ratio is 10%. What will First National Bank’s T-account statement look like if they choose to loan all but the required reserves out to borrowers? Well, if the ratio is 10% and the amount of deposits is $1,000, then the amount of required reserves is (0.10)(1000) = $100. First National Bank would then keep $100 in its reserves and loan $900 out to borrowers; its new T-account statement will look like the following. First National Bank – Statement 2Assets LiabilitiesReserves: $100 Deposits: $1,000Loans: $900Now, the money supply has $1,000 in deposits and $900 in currency from the loans, so the totalamount of the money supply is $1,900. Suppose that a borrower deposits $900 at a new bank called the Second National Bank. Initially, the Second National Bank’s T-Account statement will look like the following. Second National Bank – Statement 1Assets LiabilitiesReserves: $900 Deposits: $900Loans: $0If the reserve ratio is still 10% and Second National Bank chooses to loan all but the required reserves, then the new T-Account statement will look like the one below. Second National Bank – Statement 2Assets LiabilitiesReserves: $90 Deposits: $900Loans: $810This process of loaning all but the required reserve rate can continue indefinitely and increase the money supply. The Second National Bank can choose to loan money out again, as shown below. Second National Bank – Statement 3Assets LiabilitiesReserves: $81 Deposits: $810Loans: $729Here, we are assuming that there are no other leakages other than reserve requirements. Each time the process continues, money is created with a new loan. The table below shows the progression of deposits.Original Deposit $1,000Deposit 1 $900Deposit 2 $810Deposit 3 $729Now, the money supply is worth $3439. III. The Money MultiplierThe money multiplier is the amount of money the banking system generates with each dollar ofreserves. To calculate the money multiplier, find the inverse of the required reserve ratio, or 1/R. For the example above, if the required reserve ratio is 10%, then the money multiplier is 1/R = 1/0.1 = 10. The first deposit was worth $1,000, so multiplying this by the money multipliergives us $10,000, the total change in the money supply. 1R=1.1=10IV. Extended Bank Balance SheetWe have previously discussed a very basic bank balance sheet, but to make a more realistic balance sheet we have to introduce a few new terms. The bank capital is the resources a bank obtains by issuing equity to its owners. This is also known as the bank’s assets minus the bank’s liabilities. Leverage is the use of borrowed funds to supplement existing funds for investment purposes. The following new balance sheet is shown below.Balance SheetAssets LiabilitiesReserves: $200 Deposits: $800Loans: $700 Debts: $150Securities: $100 Capital: $50The leverage ratio is the ratio of assets to bank capital. In the example above, the leverage ratio is $1,000/$50 = 20. This means that for every $20 the bank has in assets, $1 is from bank owners while $19 is financed with borrowed