AP Macroeconomics

## Learning Outcomes

- Understand how a bank balance sheet, or T-account, records assets and liabilities
- Identify reserves, loans, and demand deposits correctly on a bank T-account
- Calculate required reserves, excess reserves, and a bank’s maximum new loan
- Explain why a cash deposit may not immediately change the money supply
- Explain how bank lending can expand the money supply through new deposits
- Apply the simple money multiplier to maximum systemwide money creation
- Avoid common AP mistakes about single-bank lending versus banking-system expansion

## AP Macroeconomics Syllabus

For the AP Macroeconomics, you are expected to understand how banks use balance sheets to track reserves, loans, and deposits, with a focus on the following syllabus points:

- Know that on a bank balance sheet, **assets** include reserves and loans, while **liabilities** include demand deposits
- Identify how a cash deposit changes both sides of a bank T-account
- Calculate **required reserves** using the required reserve ratio and demand deposits
- Calculate **excess reserves** as actual reserves minus required reserves
- Determine a single bank’s maximum new loan from its excess reserves
- Explain how lending creates new demand deposits and expands the money supply
- Distinguish between the maximum first loan by one bank and the maximum expansion for the whole banking system
- Use the simple money multiplier, **1 / reserve ratio**, only for maximum potential expansion under textbook assumptions

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. On a bank T-account, which items are assets and which are liabilities?
2. If a bank receives a $100 cash deposit and the required reserve ratio is 10%, what are required reserves and excess reserves?
3. Why does a cash deposit not necessarily change the money supply immediately?
4. If a bank has $90 in excess reserves, what is the maximum new loan it can make?
5. How is the simple money multiplier used in AP Macroeconomics problems?

## Introduction

Bank balance sheets are one of the most tested parts of AP Macroeconomics Unit 4 because they turn abstract banking ideas into visible accounting changes. If you can read a T-account, you can answer questions about reserves, loans, deposits, and money creation with much more confidence.

This topic matters because AP questions often ask you to do more than memorize a definition. You may need to update a bank’s balance sheet after a deposit, calculate excess reserves, determine the largest loan the bank can make, and then explain how that first loan can lead to a larger increase in the money supply across the banking system.

> **Key Term: T-account**
> A simplified balance sheet showing a bank’s assets on the left and liabilities on the right.

### Reading a bank balance sheet correctly

A bank balance sheet must balance. That sounds obvious, but it explains nearly every T-account question on the exam. If something increases on one side, there must be an equal change somewhere else so total assets still equal total liabilities, ignoring capital for the simple AP version.

For AP Macroeconomics, the big classification rule is:

- **Assets:** reserves, loans, and sometimes securities or other investments
- **Liabilities:** demand deposits or other checkable deposits owed to customers

Why are reserves an asset? Because they are funds the bank holds, either as vault cash or as deposits at the Federal Reserve. Why are demand deposits a liability? Because the bank owes that money to depositors on demand.

> **Key Term: assets**
> Items a bank owns or controls that have value, such as reserves and loans.
>
> **Key Term: liabilities**
> Amounts a bank owes to others, such as demand deposits.
>
> **Key Term: reserves**
> Cash in a bank’s vault plus deposits the bank holds at the Federal Reserve.

A simple deposit shows this clearly. Suppose a customer deposits **$100 cash** into a checking account.

Bank T-account:

- Assets: +$100 reserves
- Liabilities: +$100 demand deposits

The bank now has more reserves, but it also owes the depositor $100 in the checking account.

This is where many students slip: they think “deposit” must be an asset because it sounds like the bank received money. The cash received is the asset. The checking account created is the liability.

> **Key Term: demand deposits**
> Checkable deposits in bank accounts that are part of the money supply.

A second common mistake is confusing a commercial bank’s balance sheet with the Fed’s. For a commercial bank, reserves are an asset. For the Fed, bank reserve balances are a liability. On the AP exam, unless told otherwise, you are usually working with the commercial bank’s T-account.

> **Test Tip:** If a question asks you to classify an item on a commercial bank’s balance sheet, remember: reserves and loans go left; demand deposits go right.

### From deposits to required and excess reserves

Once a deposit enters the bank, the next AP step is usually to split reserves into required and excess reserves.

> **Key Term: required reserves**
> The minimum reserves a bank must hold in the textbook reserve-requirement model.
>
> **Key Term: excess reserves**
> Reserves above the required amount that can support new lending in the simple AP model.

The formulas are:

$$
\text{Required reserves} = \text{required reserve ratio} \times \text{demand deposits}
$$

$$
\text{Excess reserves} = \text{actual reserves} - \text{required reserves}
$$

Worked example:

A bank receives a **$100** deposit and the required reserve ratio is **10%**.

Step 1: Find required reserves

$$
\text{Required reserves} = 0.10 \times 100 = 10
$$

Step 2: Find excess reserves

$$
\text{Excess reserves} = 100 - 10 = 90
$$

So the bank must keep **$10** as required reserves and has **$90** in excess reserves.

You can show that on the T-account like this:

- Assets: +$10 required reserves, +$90 excess reserves
- Liabilities: +$100 demand deposits

This presentation matters because AP questions often ask for the bank’s **maximum new loan**. In the simple reserve-requirement model, the answer is not the multiplier amount. It is just the excess reserves.

So in this example, the bank’s maximum first loan is **$90**.

Why not $1,000? Because $1,000 is the maximum possible systemwide deposit expansion in the simple model when the loan is spent, redeposited, relent, and repeated throughout the banking system. One bank does not make that whole amount as its first loan.

> **Test Tip:** For one bank, maximum new lending = excess reserves. For the whole banking system, use the money multiplier only if the question asks about maximum total expansion.

A useful AP-style balance sheet example starts with an already-existing bank:

- Reserves = $200
- Loans = $1,800
- Demand deposits = $2,000
- Required reserve ratio = 10%

First calculate required reserves:

$$
0.10 \times 2{,}000 = 200
$$

So required reserves are $200. Since actual reserves are also $200, excess reserves are:

$$
200 - 200 = 0
$$

That means the bank cannot make any new loans yet. If the bank has no excess reserves, maximum new lending is **$0**.

Now suppose this bank receives a **$100 cash deposit**.

Updated T-account changes:

- Assets: reserves +$100
- Liabilities: demand deposits +$100

New totals:

- Reserves = $300
- Loans = $1,800
- Demand deposits = $2,100

Now required reserves are:

$$
0.10 \times 2{,}100 = 210
$$

Excess reserves are:

$$
300 - 210 = 90
$$

So now the maximum new loan is **$90**.

That is exactly the kind of chain AP questions like: update the balance sheet, recompute required reserves, then find excess reserves and maximum lending.

### How lending changes the money supply

The hardest distinction in this topic is this: a deposit and a loan do not affect the money supply in the same way.

Start with a **cash deposit** by the public. Suppose someone takes $100 from their wallet and deposits it into checking.

What happens?

- Currency held by the public falls by $100
- Demand deposits rise by $100

Since both currency and demand deposits count as money, total money supply does **not** change immediately. The composition changes from cash to deposits, but total money stays the same.

This is why currency in a bank vault is not counted as money in circulation. If it were counted, the same $100 would be counted twice: once as deposited money and once as vault cash.

Now compare that with a **new loan**. The bank uses the $90 excess reserves to make a loan.

Bank A changes:

- Assets: -$90 excess reserves, +$90 loans
- Liabilities: unchanged at that instant in the simple version, or matched by a new deposit claim depending on framing

In AP classroom logic, what matters next is that the borrower spends the $90, and the seller deposits that $90 into another bank. When that happens, the banking system gains **$90 of new demand deposits** without a matching fall in currency held by the public. That is why lending expands the money supply.

Cause-and-effect chain:

1. Bank gets excess reserves
2. Bank makes a loan
3. Borrower spends the funds
4. Recipient deposits the payment in a bank
5. Demand deposits rise in the banking system
6. Money supply increases

This is why AP economics says banks create money by making loans. They are not printing paper currency. They are expanding checkable deposits.

A worked chain with 10% reserve ratio:

Initial deposit from outside banking system: **$100**

Bank 1:

- Keeps $10 required reserves
- Lends $90

That $90 is spent and redeposited.

Bank 2:

- Receives $90 deposit
- Keeps $9 required reserves
- Lends $81

That $81 is spent and redeposited.

Bank 3:

- Receives $81 deposit
- Keeps $8.10 required reserves
- Lends $72.90

And so on.

The repeated redepositing is what makes the banking-system effect much larger than the first bank’s loan.

### The money multiplier and its limits

> **Key Term: money multiplier**
> In the simple textbook model, the maximum expansion of deposits from new reserves, calculated as 1 divided by the reserve ratio.

The AP formula is:

$$
\text{Money multiplier} = \frac{1}{\text{required reserve ratio}}
$$

If the reserve ratio is 10%:

$$
\frac{1}{0.10} = 10
$$

This means every $1 of new reserves can support up to $10 of maximum deposits in the simple model.

Worked example:

Initial increase in reserves = **$100**  
Reserve ratio = **10%**

Step 1: Multiplier

$$
\frac{1}{0.10} = 10
$$

Step 2: Maximum change in money supply

$$
100 \times 10 = 1{,}000
$$

So the **maximum** increase in the money supply is **$1,000**.

Why maximum? Because this result assumes:

- banks lend all excess reserves
- all loan proceeds are redeposited
- the public holds no extra cash
- there are no extra leakages

In real life, those assumptions may fail. If households keep some cash instead of redepositing it, there is a **cash drain**. If banks hold reserves above the required amount, the expansion is smaller.

Example of reduced multiplier:

If reserve requirement = 10% and banks also hold another 10% as extra reserves, effective leakage is 20%.

$$
\text{Multiplier} = \frac{1}{0.10 + 0.10} = \frac{1}{0.20} = 5
$$

Then a $10,000 reserve increase would raise the money supply by only:

$$
10{,}000 \times 5 = 50{,}000
$$

not $100,000.

This distinction matters because AP questions often say “maximum” or “potential.” That signals the simple multiplier model. If the prompt says banks hold excess reserves or the public holds cash, the actual increase will be less than the simple maximum.

One more modern note: in the United States, reserve requirement ratios were reduced to **0% in March 2020**. But AP Macroeconomics still uses required reserves, excess reserves, and multiplier logic as a teaching model. For exam purposes, follow the model given in the prompt.

> **Test Tip:** Watch for command words. “Calculate the maximum new loan” means use excess reserves. “Calculate the maximum change in the money supply” means use the multiplier.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- A bank T-account shows assets on the left and liabilities on the right
- Bank assets include reserves and loans
- Bank liabilities include demand deposits
- A cash deposit initially increases both reserves and demand deposits by the same amount
- A cash deposit does not necessarily change the money supply immediately because currency held by the public falls as deposits rise
- Required reserves equal the reserve ratio multiplied by demand deposits
- Excess reserves equal actual reserves minus required reserves
- A single bank’s maximum new loan equals its excess reserves
- Banks expand the money supply by making loans that become new deposits elsewhere in the banking system
- The simple money multiplier equals 1 divided by the required reserve ratio
- The multiplier gives a maximum potential increase, not an automatic real-world outcome
- Cash drain and banks holding extra reserves reduce actual money creation

## Key Terms and Concepts

- T-account
- assets
- liabilities
- reserves
- demand deposits
- required reserves
- excess reserves
- money multiplier


Banking and the Expansion of the Money Supply - Banks use balance sheets