AP Macroeconomics Quiz: Banking And Expansion Of Money Supply

What this quiz covers

This quiz focuses on Banking And Expansion Of Money Supply, giving you a quick way to practice the rules, question types, and explanations that matter most for AP Macroeconomics.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

Question 1

1. It is smaller because less of each loan returns to banks as new deposits. (correct answer)
2. It is larger because holding cash reduces required reserves.
3. It is unchanged because the money multiplier is still exactly $1/rr$.
4. It is zero because any currency drain prevents banks from lending.
5. It is larger because the central bank replaces the missing deposits automatically.

Explanation: Banks create money when loaned funds are redeposited, but factors like currency drain can limit this expansion. With a reserve requirement (rr) of 20%, a 10% currency drain means borrowers hold some cash, reducing redeposits and making the maximum expansion smaller than without drain, as described in choice A. This occurs because less money returns to banks for further lending, effectively lowering the multiplier below 1/rr. A common misconception is that banks print money, but they generate deposits through lending under fractional reserves, not by producing physical currency. Apply the transferable strategy of tracking deposits, deducting required reserves and drained currency, then calculating remaining loans to understand the constrained expansion process.

Question 2

1. $200 because the bank can lend only the required reserves.
2. \1{,}600$ because the bank lends the deposit minus its total reserves.
3. \2{,}000$ because the central bank provides reserves for any loan.
4. \1{,}800$ because required reserves are 10% and excess reserves are lent. (correct answer)
5. $400 because reserves are the same thing as loans.

Explanation: Banks contribute to money creation by lending excess reserves from new deposits, which then circulate as new deposits in other banks. With a reserve requirement (rr) of 10% on a $2,000 deposit, required reserves are $200, enabling the bank to lend $1,800 in the first round, as indicated in choice D. This follows because the bank lends all excess reserves after meeting the rr, even if it already holds $400 in reserves (more than required for the new deposit). A common misconception is that banks print money, but they create it by crediting borrowers' accounts, expanding checkable deposits. A transferable strategy is to track the deposit amount, subtract required reserves, and calculate potential loans, ensuring you account for any pre-existing reserves without subtracting them from the new lending capacity.

Question 3

1. It decreases because holding excess reserves reduces the amount available to lend. (correct answer)
2. It increases because higher reserves allow more lending in later rounds.
3. It is unchanged because the money multiplier depends only on $rr$.
4. It becomes $200 because reserves are the same as new deposits.
5. It increases because the central bank creates deposits to match excess reserves.

Explanation: Banks create money through lending, but holding excess reserves beyond the requirement reduces the expansion. With a reserve requirement ($rr$) of 10%, normally a \1{,}000$ deposit allows $900 in loans, but holding $200 in reserves decreases lending and thus the maximum deposit expansion, as in choice A. This happens because excess reserves tie up funds that could otherwise generate new deposits. A common misconception is that banks print money, but they expand deposits by loaning out available reserves, not by printing. Use the transferable strategy of tracking deposits, comparing held versus required reserves, and adjusting loans to see how excess holdings limit growth.

Question 4

1. $200 because banks can lend only the required reserves.
2. $800 because deposits cannot increase beyond the initial deposit.
3. \3{,}200$because the money multiplier is$rr=0.25$.
4. \3{,}200$because the money multiplier is$1/rr=1/0.25$. (correct answer)
5. \3{,}000$ because the central bank directly creates deposits equal to loans.

Explanation: Banks facilitate money creation by lending out excess reserves, which leads to repeated rounds of deposits and loans in the banking system. The reserve requirement (rr) of 25% requires holding 25% of deposits as reserves, with the money multiplier being 1/0.25 = 4 for expansion calculations. For an initial $800 deposit, this multiplier yields a maximum $3,200 increase in checkable deposits, making choice D correct. A common misconception is that banks print money, but they expand the money supply through loan creation that generates new deposits without printing currency. Use the transferable strategy of tracking each deposit, computing required reserves, and monitoring loans to see how the process multiplies the initial amount across banks.

Question 5

1. Banks create additional checkable deposits when they make loans that are redeposited. (correct answer)
2. Banks expand the money supply by lending out their required reserves each round.
3. The central bank directly credits household checking accounts when banks lend.
4. The money supply rises only when banks convert reserves into physical currency.
5. The money supply rises because reserves are counted as loans in the money supply.

Explanation: Banks create money not by printing, but by making loans that increase checkable deposits when funds are redeposited. With a reserve requirement (rr) of 20%, the process allows multiple expansions from an initial $500 deposit as loans create new deposits, best explained by choice A. This interpretation is accurate because each loan adds to the money supply through redeposition in the banking system. A common misconception is that banks print money, but they expand it via fractional reserve lending without producing currency. Utilize the transferable strategy of tracking deposits, reserves held, and resulting loans to illustrate why the money supply grows beyond the initial amount.

Question 6

1. $200
2. $800
3. $640 (correct answer)
4. \1{,}000$
5. $160

Explanation: Money creation occurs through sequential rounds of deposits and loans across multiple banks. Bank A receives $1,000 and with a 20% reserve requirement, must hold $200 in reserves, lending out $800. When this $800 is deposited in Bank B, Bank B must hold 20% of $800 = $160 as required reserves. Bank B can then lend out the remaining $800 - $160 = $640. This demonstrates how each bank in the chain can lend a smaller amount than the previous one, with the lending capacity decreasing by the reserve requirement percentage each round. A common error is thinking banks can lend their reserves or print money, when actually they create deposits by lending excess reserves. The strategy is to calculate each bank's loan as: previous bank's loan × (1 - reserve requirement).

Question 7

1. The central bank directly creates new checkable deposits whenever banks make loans.
2. Banks increase checkable deposits by creating a matching deposit when they issue loans. (correct answer)
3. Banks increase the money supply by lending out their required reserves.
4. Banks increase the money supply because reserves are counted as loans in $M1$.
5. Banks increase the money supply only if the reserve requirement is $100\%$.

Explanation: Banks increase the money supply through the loan creation process, where making a loan simultaneously creates a new deposit. When Bank A receives an $800 deposit with a 25% reserve requirement, it holds $200 as required reserves and lends $600. This loan doesn't reduce Bank A's deposits; instead, when credited to the borrower's account, it creates a new $600 deposit (either at Bank A or another bank). This new deposit can support further lending, continuing the money multiplication process. The correct answer recognizes that banks create deposits when they make loans, not that the central bank creates deposits or that banks lend their required reserves (which they must hold). A common misconception is that banks need the central bank to create new money for each loan. The strategy: understand that loans = new deposits = money creation.

Question 8

1. It is smaller because some funds leave the banking system as cash and cannot be re-lent. (correct answer)
2. It is larger because holding cash counts as additional reserves for banks.
3. It is unchanged because the reserve requirement alone determines the multiplier.
4. It becomes zero because any currency drain prevents banks from making loans.
5. It is larger because banks can lend out required reserves when cash is held.

Explanation: Currency drain reduces the money multiplier because it removes funds from the banking system's lending cycle. Without currency drain, a $1,000 deposit with a 10% reserve requirement could expand deposits by $1,000 × (1/0.10) = $10,000. However, when households hold 20% of each loan as cash, only 80% returns as deposits for the next lending round. This reduces the effective amount available for relending at each stage, shrinking the overall multiplier. The misconception that banks print money ignores how currency drain breaks the deposit-loan-redeposit chain. To analyze currency drain effects, track both the cash held outside banks and the reduced deposits available for lending—the multiplier becomes smaller than 1/rr when any funds leave the banking system.

Question 9

1. $250 because required reserves are $12.5\%$ of deposits.
2. \16{,}000$because the money multiplier is$1/0.125$. (correct answer)
3. \2{,}250$ because deposits rise by required reserves plus the initial deposit.
4. \1{,}750$ because banks can lend only the required reserves.
5. \8{,}000$because the money multiplier equals$rr$.

Explanation: The money multiplier formula determines the maximum expansion of deposits in the banking system. With a 12.5% reserve requirement, the money multiplier equals 1/rr = 1/0.125 = 8. When a customer deposits $2,000, the maximum total increase in checkable deposits equals the initial deposit times the multiplier: $2,000 × 8 = $16,000. This includes the original $2,000 deposit plus $14,000 in new deposits created through successive rounds of lending. Banks achieve this by lending out excess reserves at each stage, with each loan becoming a new deposit. A common misconception is that the multiplier equals the reserve requirement itself rather than its reciprocal. The key strategy: maximum deposit expansion = initial deposit × (1/rr), assuming full lending and no currency drain.

Question 10

1. Checkable deposits rise because banks create new deposits when they make loans backed by excess reserves. (correct answer)
2. Checkable deposits rise because the central bank directly credits new deposits to borrowers' accounts.
3. Checkable deposits rise because required reserves are lent out and then redeposited as new reserves.
4. Checkable deposits rise because reserves are identical to loans and both count as deposits.
5. Checkable deposits rise because the reserve requirement equals the money multiplier in all cases.

Explanation: Banks create new money by making loans that become deposits, not by printing currency or through central bank magic. When Bank A receives $1,000 and has a 20% reserve requirement, it keeps $200 as reserves and lends $800. This loan creates a new $800 deposit when the borrower spends it and the recipient deposits it in Bank B—now there's $1,800 in total deposits from the original $1,000 cash. Bank B then keeps 20% of $800 ($160) and lends $640, creating another new deposit, and the process continues. The key insight is that banks create deposits by crediting borrowers' accounts when making loans backed by excess reserves. Many students mistakenly think the central bank directly creates these deposits or that banks lend out their required reserves, but neither is true. Understanding that loans create deposits is fundamental to grasping how the banking system expands the money supply.

Question 11

1. Banks create additional checkable deposits when they make loans, expanding deposits systemwide. (correct answer)
2. Banks lend out required reserves, which directly adds to the money supply.
3. The central bank automatically credits new deposits whenever a bank makes a loan.
4. Reserves are counted as money, so holding more reserves increases the money supply one-for-one.
5. Banks multiply the initial deposit by the reserve requirement to create new money.

Explanation: Banks create money by making loans that become new deposits in the banking system. When a bank lends $900 from a $1,000 deposit (keeping $100 as required reserves), the borrower typically deposits this money, creating $900 in new checkable deposits. This process repeats as each bank lends its excess reserves, multiplying the initial deposit throughout the system. Answer A correctly explains this deposit creation mechanism. A common misconception is that banks lend out their reserves or that money creation requires physical printing—instead, banks create electronic deposits through lending. The key insight is that loans create deposits, not the other way around, and this process multiplies the initial deposit by up to 1/rr.

Question 12

1. Money creation is limited because banks must keep required reserves and cannot lend that portion out. (correct answer)
2. Money creation is unlimited because each bank can lend out the entire deposit each round.
3. Money creation is limited only because the central bank directly caps deposits at $600.
4. Money creation is unlimited because required reserves are treated as new loans each round.
5. Money creation is limited because banks must lend required reserves before lending excess reserves.

Explanation: Money creation is fundamentally limited by the reserve requirement, which forces banks to hold a portion of each deposit rather than lending it all. With a 50% reserve requirement, Bank A must keep $300 of the $600 deposit as reserves, lending only $300. This high reserve requirement severely restricts the multiplier to just 1/0.50 = 2, meaning maximum deposits can only reach $600 × 2 = $1,200. The process is self-limiting because required reserves reduce the amount available for lending at each round. The misconception that banks print unlimited money ignores this mathematical constraint—banks can only lend excess reserves, not required reserves. The strategy for understanding limits is to recognize that higher reserve requirements mean lower multipliers and less money creation potential.

Question 13

1. $100
2. \6{,}400$
3. $800
4. \5{,}600$ (correct answer)
5. \1{,}600$

Explanation: Banks create money by lending excess reserves, which multiply through the banking system as loans become new deposits. With a 12.5% reserve requirement, Bank A holds $100 (12.5% of $800) as required reserves and lends the remaining $700. The money multiplier equals 1/0.125 = 8, meaning each dollar of excess reserves can create up to $8 in new deposits. Therefore, the maximum increase in checkable deposits is $700 × 8 = $5,600. This doesn't include the original $800, which already exists—we're calculating only the new deposits created. Many students confuse the total deposits with the increase in deposits, but the question asks specifically for the increase. The calculation strategy is: find excess reserves from the initial deposit, then multiply by (1/rr) to get the maximum possible expansion.

Question 14

1. \1{,}000$, because deposits cannot exceed the initial deposit.
2. \5{,}000$, because the money multiplier is$1/rr$. (correct answer)
3. $200, because banks can lend only their required reserves.
4. $800, because excess reserves equal $1-rr$ of the deposit.
5. \2{,}000$, because the multiplier equals$rr$.

Explanation: Banks play a vital role in money creation by accepting deposits and lending out excess reserves, which generates new checkable deposits across the banking system. The reserve requirement of 20% dictates that banks must hold 20% of each deposit as reserves, allowing them to lend out 80% and fuel further deposit creation. For an initial \1{,}000$deposit, the money multiplier of$1/0.2 = 5$enables a maximum increase in the money supply to$$5{,}000$, as each round of lending creates new deposits that multiply the initial amount, making choice B correct. A common misconception is that banks print money like a central bank, but they actually expand the money supply through fractional reserve lending without physically printing currency. A transferable strategy is to track the initial deposit, compute required and excess reserves at each step, and sum the chain of loans and resulting deposits to verify the total expansion.

Question 15

1. \1{,}000$ because deposits do not change when banks lend.
2. \4{,}000$ because required reserves equal 20% of the deposit.
3. \5{,}000$because the money multiplier is$1/rr=1/0.20$. (correct answer)
4. $800 because banks can lend only the required reserves.
5. \5{,}000$ because the central bank directly creates deposits when banks lend.

Explanation: Banks play a crucial role in money creation through fractional reserve banking, where they lend out portions of deposits, leading to new deposits across the system. The reserve requirement (rr) of 20% means banks must hold 20% of deposits as reserves, allowing them to lend 80% and initiate the expansion process. For an initial $1,000 deposit, the money multiplier of 1/0.20 = 5 results in a maximum $5,000 increase in checkable deposits, explaining why choice C is correct. A common misconception is that banks print money like a central bank, but they actually create deposit money by issuing loans that recipients deposit elsewhere. To solve these problems, use the transferable strategy of tracking the initial deposit, calculating required reserves, and following the chain of loans and new deposits through multiple rounds. This approach highlights how the total money supply expands beyond the initial amount.

Question 16

1. \12{,}800$because the money multiplier is$1/rr=1/0.125$. (correct answer)
2. \1{,}400$ because banks can lend only the required reserves.
3. $200 because required reserves are 12.5% of the deposit.
4. \20{,}000$because the money multiplier is$rr=0.125$.
5. \12{,}800$ because the central bank directly multiplies deposits by eight.

Explanation: Banks expand the money supply by lending excess reserves, creating new deposits as loans are spent and redeposited. The reserve requirement (rr) of 12.5% sets the money multiplier at 1/0.125 = 8, guiding the total expansion. For an initial $1,600 deposit, this results in a maximum $12,800 increase in checkable deposits, confirming choice A. A common misconception is that banks print money, but they create it via the lending process that multiplies deposits without issuing new currency. Employ the transferable strategy of tracking the deposit, determining required reserves, and projecting loans across rounds to compute the full multiplier effect.

Question 17

1. $300, because banks can lend only required reserves.
2. \1{,}200$, because the money multiplier is$1/rr=2$. (correct answer)
3. $600, because banks cannot create deposits through lending.
4. \1{,}100$, because the multiplier equals$rr=0.5$.
5. $900, because banks lend out required reserves and keep excess reserves.

Explanation: Banks expand the money supply by lending excess reserves from initial deposits, creating a multiplier effect across the system. For a 50% reserve requirement, the multiplier is $1/0.5 = 2$, leading to a maximum increase in checkable deposits of $1,200 from a $600 deposit, correctly captured in choice B. This happens as half of each deposit is lent and redeposited, doubling the initial amount through the chain. Many wrongly believe banks print money, but they create it by issuing loans that become new deposits. Apply the strategy of tracking each deposit, calculating reserves and loans, and summing the geometric series for total expansion.

Question 18

1. Borrowers and banks may choose to hold more currency or excess reserves, reducing redepositing. (correct answer)
2. Banks are required to lend out required reserves before making any loans.
3. The central bank creates checkable deposits automatically for each loan issued by banks.
4. The reserve requirement guarantees that loans will equal total reserves in the system.
5. The money multiplier equals $rr$, so a higher $rr$ always increases total deposit creation.

Explanation: The theoretical money multiplier 1/rr assumes perfect conditions where all excess reserves are lent and all loans are redeposited. In reality, borrowers may hold cash instead of depositing loan proceeds, and banks may choose to hold excess reserves for safety or lack of creditworthy borrowers. These behavioral factors create "leakages" that prevent the system from reaching the theoretical maximum, making answer A correct. Students often think the multiplier formula guarantees a specific outcome, but it represents a maximum under ideal conditions. The key insight is that the money multiplier formula shows potential, not guaranteed results—real-world frictions always reduce actual money creation below the theoretical maximum.

Question 19

1. $0.2$
2. $2$
3. $4$
4. $5$ (correct answer)
5. $20$

Explanation: The money multiplier represents how much the banking system can expand deposits from an initial injection of reserves through repeated lending. With a 20% reserve requirement, banks must hold $0.20 of every dollar deposited, leaving $0.80 to lend. This creates a geometric series: $1 + $0.80 + $0.64 + $0.512 + ..., which sums to 1/(1-0.80) = 1/0.20 = 5. Therefore, each dollar of initial reserves can support up to $5 in total deposits throughout the banking system. Many students confuse the reserve requirement (20% or 0.20) with the multiplier itself, but they are reciprocals of each other. The simple formula to remember is: Money Multiplier = 1/rr, where rr is the reserve requirement expressed as a decimal.

Question 20

1. It reduces the maximum increase in deposits because fewer loaned funds return as new deposits. (correct answer)
2. It increases the maximum increase in deposits because currency counts as reserves for lending.
3. It has no effect on the maximum increase in deposits because the reserve requirement is unchanged.
4. It makes the maximum increase in deposits equal to the initial deposit because banks stop lending.
5. It makes the central bank create deposits directly to replace the withdrawn currency.

Explanation: Currency drains reduce the money multiplier effect because withdrawn cash doesn't get redeposited to generate new loans. When borrowers hold currency instead of depositing loan proceeds, less money flows back into the banking system for further lending. With a $100 currency drain each round, only $900 of each $1,000 loan gets redeposited, reducing the cumulative deposit creation compared to the theoretical maximum of 1/0.20 = 5 times. Answer A correctly identifies this reduction effect. Students often mistakenly think currency held by the public counts as bank reserves—it doesn't. The strategy is to recognize that any leakage (currency drain or excess reserves) reduces the effective money multiplier below 1/rr.