Future Business Leader Achievments (FBLA) Economics Practice Exam

How does borrowing from a bank affect the money supply?

1. Decreases the supply of money

2. Increases the supply of money by increasing demand deposits

3. Has no effect on the money supply

4. Reduces the total amount of currency in circulation

The correct answer is: Increases the supply of money by increasing demand deposits

Borrowing from a bank affects the money supply by increasing it through the creation of demand deposits. When a bank lends money, it usually does not hand over physical cash but rather credits the borrower's account with a deposit. This transaction boosts the total amount of money in the banking system because demand deposits are part of the money supply. As banks lend out a portion of their deposits (while holding a fraction as reserves due to reserve requirements), they effectively create additional money in the economy. This process is known as fractional reserve banking. Thus, when individuals or businesses borrow funds, they not only receive that amount but also contribute to an increase in overall demand deposits, enhancing the money supply available for spending and investment in the economy. This is a fundamental concept in monetary policy and banking theory, illustrating how lending activities can stimulate economic growth by making more funds available for various uses.