Since demand deposits commonly called checking accounts are a significant part of M1 changes in the levels of checking accounts have a impact on the supply of money. Of course if Professor Stone takes $100 from under his mattress and deposits it in his checking account at Chase the supply of money does not change. But if Chase lends some of this new $100 deposit out to Mr. X, the checking account of Professor Stone will still record a balance of $100 but M1 will have increased by more than the $100 deposit made by Professor Stone. Does this make sense. Banks do not hold all deposits in reserve only a fraction of deposits are held as reserves.

What is the incentive for banks to lend out deposits?

Banks tend to make medium and long term loans that are financed with short term liabilities. What are these liabilities and what is the risk of this type of financial management?

For those of you who have checking accounts at a bank, what risks do you incur by lending to the bank?

The value of a banks Assets less the Value of its Liabilities is equal to the value of the banks equity also called net worth.

Asset Value = Liability Value + Bank Equity Value

Asset Value-Liability Value = Bank Equity Value

Assets would include mortgages, commercial loans, real estate, cash.

Liabilities would include deposits and other forms of debt.

If the bank managers decide to issue shares of stock to the public the proceeds would go on the balance sheet as cash and this would increase the value of bank equity.

1) What happens to the value of bank equity when the value of mortgages declines?

2) What happens to the Net Worth of a bank when the value of its assets falls relative to the value of its liabilities?

3) What will happen to bank profits if the cost of funds increases but the interest earned on assets remains the same?

4) What happens to bank profits if borrowers begin to default at higher rates?

5) What happens to a bank's net worth as the value of loans declines because the loans do not perform as expected?