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Show Me the Money! A Fractional Reserve Banking Simulation

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Lesson Overview

Fractional Reserve Banking is a fundamental part of all modern economies.  First introduced in Europe in the 16th Century, bankers ever since have made sure to lend out most – but not all – of the deposits held by their institutions.  Originally the reason for holding a fraction in reserve was to protect the bank in case many or most of its depositors needed cash at the same time.  Today there are reserve requirements imposed on American banks by the Federal Reserve System in its ongoing effort to manage the nation’s money supply.

Whether imposed by prudence or a banking regulation system, fractional reserve banking enables banks to “create money” through lending, thereby expanding the money supply during times of economic growth.  In this activity, students will learn to:

  • calculate the amount of money created by banks in the classroom economy;
  • appreciate the role of banks as creators of money; and
  • understand the importance of fractional reserve banking in the process of money creation.

Video Demonstration

Content Standards Addressed

National Voluntary Content Standards in Economics

Standard 10:  Institutions evolve in market economies to help individuals and groups accomplish their goals. Banks, labor unions, corporations, legal systems, and not-for-profit organizations are examples of important institutions. A different kind of institution, clearly defined and enforced property rights, is essential to a market economy.

Standard 11:  Money makes it easier to trade, borrow, save, invest, and compare the value of goods and services

Activity Guide

Time:

45 to 50 minutes

Materials 

  • Copies of Handout 1 for entire class
  • Up to 6 Copies each of Handouts 2-1, 2-2, 2-3 and 2-4 for bankers  (It's best to staple the four pages of handout 2 together before the simulation)
  • Three copies of Handout 2-5 per bank  (These should be cut up with scissors before the simulation begins.)
  • Copies of Handouts 3, 4 & 5 (8 or 9 copies of each)
  • Overhead or copies of Handout 6 for entire class
  • Overhead or copies of Handout 7 for entire class
  • 6 Calculators
  • Chocolate or candy to give as prizes

Procedures:

  1. General discussion: Where does money come from? This can be done with a question on the white board, or a short writing assignment that students can answer at their desks.  Students will normally say from "the government", which isn't wrong.  The direction you want to suggest, however, is that there may be other agencies out there creating money every day.
  2. Explain that today's activity is designed to answer the question of where money comes from.  Then go over the role descriptions with the class (Handout 1).  When the class understands the roles and general procedure of the game, select students for each role.
    • Roles for a class of 35:
      • 6 Banks - 2 students per bank - Handout 2 for each bank
      • Three pages of handout 2.5 per bank, cut apart
      • 23 Borrowers - Handout 3, 4 & 5 (7 or 8 copies of each)
    • For smaller classes: The ratio of bankers to borrower should be about six borrowers per bank, so a class of 25 would have 4 banks, a class of 20 can get by with only 3 banks.
  3. Round 1:  Give students a moment to read over the particulars of their roles, and then ask if everyone is ready for round one.  At this point there are two things to stress with your classes:
    • First, borrowers can borrow only one time per round of the game. 
    • Second, no cash changes hands in this game.  Borrowers get Loan Certificates rather than money.
    • Third, successful borrowers must deposit their loan certificates into a bank other than the one which lent them the funds.  This is important for students to understand - loans become deposits.  You'll return to this idea in the debriefing of round 1
    • When everyone is ready, go ahead into the first round of the activity, allow borrowers to mingle with bankers and attempt to get funding for their special projects.  Round one should last about five minutes - enough time for every borrower to speak to at least two bankers.  Successful borrowers will get loan certificates (handout 2.5) which will be essential for round 2 of the game.
  4. Debrief round 1, asking the following questions.
    • How many borrowers were able to get funding in round 1?
    • For those who were turned down, why did the bank say no? 
    • How many bankers met their goal of lending 80% of their assets?
    • When those dollars were lent, where did they go?(The answer to the last question is crucial.  When banks lend money it inevitably appears as deposits in some part of the banking system.  You can discuss this for a minute with the class.  When a bank lends money to someone, it creates deposits for that person.  The person then spends the money on a car or something else, but the seller of the car puts the loaned funds into a bank before paying his employees - banks are central to nearly every transaction in an economy.)
    • Each bank started with $10,000 - Bankers do you have more than that now?  How come?
    • What is all that extra money doing in the economy?
  5. Round 2:  Successful Round 1 borrowers must deposit their funds.  They can deposit them in any bank other than the one where they borrowed.   Bankers need to record their deposits on the Bank Balance sheet.  This step shows students that loans from one bank become deposits in another bank after the money is used (spent) by the borrower.  This should take about 3 minutes.
    • After all the bankers have calculated how much they have in new deposits remind them that they can only lend 80% of the new deposits.  This should take the bankers about 2 or 3 minutes to calculate.
    • Go on with borrowing activity in round 2.  Round 2 lasts roughly five minutes.
  6. Debrief round 2 using the following questions:
    • Did all borrowers make deposits into another bank?  (The answer here needs to be yes.  All loans must become deposits somewhere.)
    • Borrowers how did you decide which bank to deposit in?  How do people decide in real life?  (In real life interest rates attract borrowers, but in this simulation we're keeping things simple in order to focus on the concept of money creation.)
    • Did all bankers receive some new deposits?  (This answer, too, must be yes.  Every bank should have new deposits, but some will have more than others.)
    • What do you think this symbolizes in the actual economy?  (In the actual economy this symbolizes what happens to the money after the borrowers spend it.  Whoever receives those funds puts them into the bank - so a loan in one bank becomes a deposit in another bank.)
    • Bankers, do you know how to figure out how much you have to lend in round 3? (This is where the calculator comes in handy - bankers can lend only 80% of their new deposits in round 3.)
    • Borrowers, are you ready?
    • You may have some students who have achieved their goal after round 2.  If so, reward them with candy (or whatever reward you're using) and tell them to sit quietly.  If you want to include those students who have finished you can make them bank examiners to check the math of each bank in the simulation.
  7. Proceed to round 3:   In Round 3 successful round 2 borrowers must deposit their funds.  They can deposit them in any bank other than the one where they borrowed.  Bankers need to record their deposits on the Bank Balance sheet.  This step shows students that loans from one bank become deposits in another bank after the money is used (spent) by the borrower.  This should take about 3 minutes.
    • After all the bankers have calculated how much they have in new deposits remind them that they can only lend 80% of the new deposits.  This should take the bankers about 2 or 3 minutes to calculate.
    •  At the end of round 3 direct the bankers to start working on their Banking Summary Sheet (the last page of handout 2).  Debrief the borrowers as the bankers record their data.
  8. Debrief round 3 using the same questions that you used for round 1:
    • How many borrowers were able to get funding in round 3?
    • For those who were turned down, why did the bank say no? 
    • How many bankers met their goal of lending 80% of their assets?
    • When those dollars were lent, where did they go? (The answer to the last question is crucial.  When banks lend money it inevitably appears as deposits in some part of the banking system.  You can discuss this for a minute with the class.  When a bank lends money to someone, it creates deposits for that person.  The person then spends the money on a car or something else, but the seller of the car puts the loaned funds into a bank before paying his employees - banks are central to nearly every transaction in an economy.)
    • Each bank started with $10,000 - Bankers do you have more than that now?  How come?
    • What is all that extra money doing in the economy?
  9. Calculate the money supply:  Once the bankers have gathered their data, write the numbers on the white board.  Go to the graphing the money supply handout. (Handout #6)  Have a student in class add it up using a calculator and then graph the growth in money from round 1 to round 3.  Have students fill in the graph with the amounts of total deposits in each round.
    • Handout 6 can also be used as a written assessment for the simulation also.  Once you have the bankers' data, write it up on the whiteboard or on an overhead.  Have the kids graph it and then answer the question in writing at the bottom of the page.  They can write their names on the top and you can collect them.
  10. Give chocolate or candy to the bankers who got the most bonus cash, and to the borrowers who were able to achieve their borrowing goals.  This should be all borrowers by the end of round 3.
  11. Debrief.

Debriefing:  Teacher Guide

  1. In this activity the incentive for banks to make loans was bonus points/candy.  What incentive do banks have for making loans in the real world?  What incentive do people have for keeping their money in the bank?     Interest.  In the real world banks are "borrowing" money from depositors (to whom they pay interest) and lending it to borrowers (who pay interest to the bank). 
  2. We started with a money supply of only $50,000.  We finished with a whole lot more than that.  Where did the extra money come from?  Loans that each bank made in an early round became deposits for a later round.  This is how banks “create money.”  Loans they make eventually become deposits in banks which can then be used to make new loans.
  3. What would the borrowers do with all the money they borrowed?  Would their activity be helpful or harmful for an economy?  How can you tell?  The borrowers would be hiring people to remodel their homes, buying cars and investing in college educations.  All three of these activities would stimulate demand in the economy and could potentially be very helpful.  If the economy were in a slow period this could be helpful.  If the economy were already humming along near the peak of the business cycle then more lending could create inflation.
  4. In our simulation all of the loans were "good" loans because the borrowers all paid them back.  What would happen in an economy where people stopped paying back their loans?  What would banks be forced to do?    When people stop paying their loans off banks have to declare those loans to be "losses".  This makes the bank less profitable and also makes the bank much more cautious about lending money.  When the banks slow or stop their lending the economy will slow down overall.  Banks might be forced to repossess things purchased with borrowed money, or even to demand payment all at once from some of their other borrowers in order to stay in business.
  5. Our reserve requirement in this simulation was 20%.  What would happen to the simulation if it were changed to 30%?  How about if it were changed to only 10%?  If the reserve requirement is raised to 30% then banks would lend less money, few bonus dollars would be earned and fewer borrowers would achieve their goals.  If the reserve requirement were dropped to only 10% then bankers would lend more money, earning more bonus dollars and borrowers could achieve their goals.
  6. Most economics textbooks say that banks "create" money.  After our simulation do you agree?  Why or why not? Most kids should agree with this by the end of the simulation, but there are some other views which are just as accurate.  Some students could say that the same dollars are in more than one place, as indeed they are.  Eighty percent of the bank deposits are loaned out, but they're still considered as being "in the bank."