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Trace loans, deposits, reserves, equity, and a restricted reserve-ratio experiment.
Paper packet. Every task here also exists on screen, where it is checked automatically; answers written on paper are not assessed by Nydus. When you are back at a device, enter your answers there.
Construct bank balance sheets through loan origination, settlement, repayment, and losses; distinguish money functions and aggregates; and calculate a fictional deposit multiplier without treating it as a mechanical modern banking law.
Circular-flow accounts record spending during a period. Bank balance sheets record assets, liabilities, and equity at a date. This lesson follows the entries behind loans and payments before introducing a restrictive reserve-ratio illustration. Distinguishing those two models prevents the illustration from being mistaken for a mechanical description of modern banking.
| Term | What it means |
|---|---|
| Medium of exchange | Something accepted in payment for goods, services, or obligations. |
| Unit of account | The common denomination used to quote prices and record debts. |
| Store of value | An asset's ability to transfer purchasing power across time, with possible risk or erosion. |
| Bank deposit | A bank liability to its customer and an asset of that customer. |
| Reserves | Bank-held central-bank balances and, in the specified convention, qualifying vault cash used for settlement or reserve requirements. |
| Bank equity | Assets minus liabilities, the residual cushion absorbing losses. |
A fictional commercial bank grants a customer a twenty-dollar loan by crediting the customer's deposit account. The bank records a twenty-dollar loan asset and a twenty-dollar deposit liability. The customer records a twenty-dollar deposit asset and a twenty-dollar loan obligation. No bag of previously saved currency has to be moved from another customer's account at the instant these entries are created.
The deposit is spendable bank money under the scenario's payment arrangements. Creating it does not create twenty dollars of net wealth for the borrower, because the matching debt also exists. Nor does it create unlimited real resources for the economy. If the customer spends the deposit, the payment must be accepted and settled, and the bank must manage funding, liquidity, capital, credit risk, regulation, and profitability.
Reserves are different from customers' deposits. A household normally pays with its bank deposit or currency, not by transferring its own account at the central bank. Banks use reserve balances to settle payments with one another. A bank can create a customer deposit through lending, but it cannot create central-bank reserve balances by writing the same loan entry. The distinction between these liabilities is central to understanding both banking and monetary policy.
Another way: steps
Identify whose balance sheet is being recorded. Enter each asset and liability change at loan origination. Trace any payment to another bank separately through reserves and deposits. Check assets equal liabilities plus equity after every event.
Suppose Bank A begins with forty dollars of reserves and 160 dollars of loans, making total assets of two hundred. It has 180 dollars of customer deposits and twenty dollars of equity. Assets equal liabilities plus equity: 200 = 180 + 20. Reserves are an asset of Bank A; customer deposits are its liability. Reversing those positions confuses the bank's accounts with its customer's accounts.
After the new twenty-dollar loan, reserves remain forty, loans rise to 180, deposits rise to two hundred, and equity remains twenty. Assets are now 220, equal to two hundred of deposits plus twenty of equity. The loan initially expands both sides of the balance sheet without changing reserves or equity. This is an accounting description of a granted loan, not a claim that the bank faced no constraint in deciding whether to grant it.
If the borrower pays twenty dollars to a seller at Bank B, Bank A's deposit liability falls by twenty and its reserves fall by twenty during settlement. Bank B's reserves rise by twenty and its deposit liability to the seller rises by twenty. Across the two banks, reserves have moved rather than increased. The banking system still has the additional twenty-dollar deposit created by the loan, now held at the receiving bank.
Bank A therefore ends this sequence with twenty reserves, 180 loans, 180 deposits, and twenty equity. Its balance sheet totals two hundred on each side. The loan asset remains even though the new deposit left the bank. A bank that repeatedly loses deposits through outgoing payments needs a way to manage the resulting funding and liquidity position. Deposit creation at origination does not eliminate settlement needs.
If a customer repays loan principal using a deposit at the same bank, the bank reduces its loan asset and its deposit liability by the repaid amount. Broad deposit money is extinguished in that simple transaction. Interest payments and fees have different income and equity effects, so the exercise specifies principal repayment when making this cancellation claim. A default also differs: writing down a loan reduces the bank's assets and, absent other changes, its equity rather than automatically canceling another customer's deposit.
Liquidity concerns the ability to meet payments when due, using available cash, reserves, or assets that can be converted or financed on acceptable terms. Solvency concerns whether asset value is sufficient relative to obligations, with equity providing a loss-absorbing cushion. A bank can face an urgent liquidity problem even if its assets are valuable over time. Conversely, ample liquid balances do not by themselves prove that the total asset portfolio covers liabilities.
In the initial Bank A example, a ten-dollar loss on loans would reduce loan assets and equity by ten if all other entries remain unchanged. Deposits remain 180 and reserves remain forty. The bank's equity cushion shrinks from twenty to ten. This illustrates why reserves and capital are not interchangeable words. Holding settlement balances and bearing credit losses are different balance-sheet functions.
Lending decisions respond to expected repayment, interest margins, funding costs, capital and liquidity requirements, risk limits, and the demand for credit from suitable borrowers. Even a bank with abundant reserves need not make a loan it expects to lose money on. Conversely, a bank expecting a profitable loan can consider how to obtain or retain funding and settlement liquidity. There is no universal rule that its current reserve balance alone fixes the exact number of loans it will grant.
At the banking-system level, a loan that sends deposits from one bank to another redistributes reserves during settlement. An individual bank cannot assume that the receiving deposits stay with it, while the system cannot be analyzed by treating every interbank outflow as a loss of reserves from the system as a whole. The unit of analysis matters just as it did for households and the national accounts.
The central bank influences monetary and funding conditions, but its tools and operating framework must be specified. In an ample-reserves regime, administered interest rates can guide short-term market rates without mechanically forcing a predetermined quantity of bank loans through a fixed reserve multiplier. A later lesson compares that implementation with a limited-reserves model. Here the important accounting result is that reserves, deposits, loans, and equity are different objects linked by transactions and constraints.
Now introduce a deliberately fictional system with a required reserve ratio of twenty percent. Assume banks hold no excess reserves, every loan is spent and redeposited in this banking system, the public makes no further currency withdrawals, all proposed loans are granted, and capital or liquidity limits do not bind beyond the stated ratio. A person deposits one hundred dollars of currency that was previously held outside banks.
The first bank keeps twenty dollars as required reserves and makes an eighty-dollar loan. The loan is spent and redeposited, allowing the next bank to keep sixteen and lend 64. Repeating the same process yields a geometric sequence of deposits. The maximum total deposit increase is the initial one hundred divided by 0.2, or five hundred dollars. Total new lending in this particular cash-deposit experiment is four hundred dollars, because the first one hundred dollars of deposits came from existing public currency.
The distinction between deposits and money is essential. At the initial deposit, public currency falls by one hundred and deposits rise by one hundred, leaving a currency-plus-deposits aggregate unchanged. As the subsequent loans create four hundred additional deposits under the assumptions, that aggregate rises by four hundred. Calling the whole five hundred a net increase in broad money would ignore the currency that was already money before entering the bank.
Change the initial transaction and the interpretation can change. A central-bank purchase from a bank swaps securities for reserves without necessarily creating a customer deposit at that moment. A purchase from a nonbank seller can create both reserves and a deposit through the seller's bank. These transactions should not be collapsed into the phrase injects money without saying which balance sheets and monetary aggregate changed.
The reciprocal ratio is not a mechanical law governing actual modern lending. Excess reserve holdings, currency demand, capital constraints, credit demand, risk, and the monetary operating framework all matter. A zero reserve requirement does not imply infinite deposits or infinite loans. It means the simple required-reserve constraint no longer supplies a finite bound through that formula; other constraints remain. The current institutional account and the fixed-ratio classroom model serve different explanatory purposes.
Money's functions also do not make every asset part of the same measured aggregate. A highly liquid deposit can serve payments directly under one definition, while a bond may store value but require sale before making a purchase. An aggregate must specify what it includes. Our exercises use currency held by the public plus customer deposits when discussing broad money, and bank reserves when discussing settlement, so the arithmetic is not dependent on an unstated national classification.
A fictional bank starts with reserves forty dollars, loans 160, customer deposits 180, and equity twenty. It grants a twenty-dollar household loan by crediting a deposit, and the household immediately pays a seller at another bank. A commentator says the bank handed twenty reserve dollars to the household, which then put them into the seller's central-bank account. That story mixes the liabilities used by customers with the assets banks use for settlement.
At origination the bank adds a twenty-dollar loan asset and a twenty-dollar deposit liability. Its reserves remain forty. During the payment, the household's deposit at the originating bank falls by twenty, and the bank transfers twenty reserves to the receiving bank. The receiving bank credits the seller's deposit by twenty. The household and seller transact through bank deposits; the two banks settle through reserve balances.
After settlement the originating bank has twenty reserves, 180 loans, 180 deposits, and twenty equity. Across the two banks, total reserves are unchanged by the private interbank transfer, while deposits are twenty dollars higher than before the loan. The loan remains an asset and the borrower remains obligated to repay. Deposit creation therefore expands a monetary liability without generating net wealth for the borrower.
The corrected account should also avoid saying that this bank can lend without limit. Losing reserves and deposits through payments affects its liquidity and funding position, while the additional loan changes risk and capital needs. These constraints require economic and institutional analysis beyond the accounting entries. The ledger establishes what happens when a specified loan and payment occur; it does not guarantee that every proposed loan will be approved.
Customer deposits are bank liabilities; reserves and loans are bank assets. Equity is a loss-absorbing residual, not a synonym for reserves. Loan origination creates a deposit and a debt together. Interbank settlement moves reserves rather than creating them. The reciprocal reserve-ratio illustration requires restrictive assumptions and is not a mechanical description of modern ample-reserves banking.
Verify the initial balance sheet.
Assets 40 reserves + 160 loans = 200; deposits 180 + equity 20 = 200.
The starting identity must hold before a transaction is added.
Enter the new loan asset.
Loans rise by twenty to 180 dollars.
The bank acquires the borrower's repayment obligation as an asset.
Enter the matching deposit liability.
Deposits rise by twenty to 200 dollars.
The borrower receives a spendable claim on the bank.
Keep unaffected entries unchanged.
Reserves remain forty and equity remains twenty.
The origination entry alone neither transfers reserves nor records a profit.
Reconcile the expanded balance sheet.
Assets 220 = deposits 200 + equity 20.
Both sides rise together by the loan amount.
Start immediately after loan origination.
Bank A has forty reserves and two hundred deposits.
The new twenty-dollar deposit exists before the payment.
Debit the paying customer's deposit.
Bank A deposits fall to 180.
The customer's claim on Bank A is reduced by the purchase amount.
Transfer settlement balances.
Bank A reserves fall to twenty; Bank B reserves rise by twenty.
The system's reserve total is unchanged by this interbank transfer.
Credit the seller's receiving deposit.
Bank B deposits rise by twenty.
The seller receives a bank-money claim rather than a personal central-bank reserve account.
Check Bank A and the system separately.
Bank A assets 200 = deposits 180 + equity 20; system deposits remain twenty higher than before the loan.
A deposit can leave one bank while remaining in the banking system.
State the initial transaction and restrictions.
One hundred dollars of public currency is deposited; reserve ratio 20%; no excess reserves or further currency leakage.
The transaction's origin determines what counts as new money.
Calculate the first lending round.
Keep twenty reserves and lend eighty dollars.
The first bank obeys the fictional required ratio exactly.
Calculate the next redeposit round.
Eighty is redeposited; keep sixteen and lend 64.
The experiment assumes all lending returns as deposits somewhere in the system.
Sum the maximum deposit sequence.
100/0.2 = 500 dollars of additional deposits.
The geometric sum depends on every stated restriction.
Separate new loans from converted currency.
New loans total 500-100 = 400 dollars.
The first deposit was existing money changing form, not newly created lending.
Calculate the broad-money change and limit the claim.
Public currency falls 100, deposits rise 500, so net change is +400 dollars.
This conditional ceiling is not a forecast or an automatic rule for modern banks.
Identify the matched assets and liabilities.
A customer owes fifteen dollars of loan principal and holds a sufficient deposit at the same bank.
The case concerns principal only, excluding interest and fees.
Record the repayment entries.
Loan assets fall fifteen; deposit liabilities fall fifteen.
The repayment cancels the bank's claim and the customer's spendable claim together.
State the monetary implication within scope.
A fictional bank has reserves thirty dollars, loans 170, deposits 180, and equity twenty. It grants a forty-dollar loan by crediting a new customer deposit. No payment leaves the bank yet. Complete the new balance sheet.
| Dollars | |
|---|---|
| Reserves | |
| Loans | |
| Deposits | |
| Equity |
A fictional bank has reserves twenty-five dollars, loans 175, deposits 180, and equity twenty. It grants a thirty-dollar loan and credits a deposit, with no outgoing payment. Complete the changed entries and total assets.
Add the new loan asset.
New loans=loans dollars.
The bank records the borrower's repayment obligation.
Add the corresponding customer liability.
New deposits=deposits dollars.
The granted loan credits a spendable deposit at the same bank.
Sum the asset side after origination.
Total assets=assets dollars.
Reserves are unchanged because no settlement payment has occurred.
Immediately after a fictional loan, Bank A has reserves fifty dollars, loans 250, deposits 270, and equity thirty. Its customer pays twenty dollars to someone at Bank B. Settlement transfers twenty reserves from A to B. Complete Bank A's new entries and Bank B's changes.
| Dollars | |
|---|---|
| A reserves | |
| A loans | |
| A deposits | |
| B reserve change | |
| B deposit change |
Construct the critique of the claim that creating deposits lets a bank lend without limits. The supplied facts concern outgoing settlement needs and credit losses.
This task has no paper form; do it on a device.
In a deliberately fictional system, a customer deposits eighty dollars of previously held public currency. Required reserve ratio is 25%; banks hold no excess reserves, all loans are redeposited, no further currency is withdrawn, and no other constraint binds. Compute maximum additional deposits, new loans, and the change in public currency plus deposits.
| Dollars | |
|---|---|
| Additional deposits | |
| New loans | |
| Broad-money change |
A fictional cooperative bank holds reserves sixty dollars and loans 240, with deposits 270 and equity thirty. It writes down ten dollars of loan principal as an unrecoverable loss. No deposit is canceled and no payment occurs. Complete the new balance sheet.
| Dollars | |
|---|---|
| Reserves | |
| Loans | |
| Deposits | |
| Equity |
Lesson test: one question per skill, one attempt each, no hints. Your answers are checked when you submit.
A fictional bank starts with reserves eighty dollars, loans 320, deposits 350, and equity fifty. It grants a forty-dollar loan by crediting a deposit; the borrower then pays all forty to a seller at another bank, with equal reserve settlement. Compute the originating bank's final reserves, loans, deposits, equity, and the banking system's deposit change from before the loan.
| Dollars | |
|---|---|
| Final reserves | |
| Final loans | |
| Final deposits | |
| Final equity | |
| System deposit change |
You can explain how a loan creates a deposit, why settlement still matters, and why a reserve-ratio illustration needs explicit restrictions. Next, connect financial-asset prices to promised payments and yields.
13. Principal repayment using a deposit, step 3
Deposit money falls fifteen dollars; no reserve transfer is required for this same-bank entry.
The result differs from a loan default, which reduces equity through an asset loss.