The Money Multiplier Marginal Revolution University English (auto-generated) English

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now that we know how money is defined

[Alex] Now that we know how money is defined,

will learn how banks can affect the

we'll learn how banks can affect the supply of money

supply of money through fractional reserve banking let's imagine that you

through fractional reserve banking.

graduate from college and your grandma

Let's imagine that you graduate from college

gives you a thousand dollars in cash

and your grandma gives you $1,000 in cash --

that she's been saving under her mattress since the 1970s and you deposit

that she's been saving under her mattress since the 1970s.

this cash in your checking account

And you deposit this cash in your checking account.

what does the bank do with your money

What does the bank do with your money?

does it sit in a vault with your name on

Does it sit in a vault with your name on it?

it no banks lend most of your money to people who want to borrow banks keep in

No. Banks lend most of your money to people who want to borrow.

reserve only a fraction of your money

Banks keep in reserve only a fraction of your money --

money be keep in cash for the ATM or to

money they keep in cash for the ATM

meet withdrawal demands this is why this

or to meet withdrawal demands.

system is known as fractional reserve

This is why this system is known as "fractional reserve banking."

banking so what fraction of your deposit do banks keep in reserve well large

So what fraction of your deposit do banks keep in reserve?

banks in the United States must keep in

Well, large banks in the United States

reserve at least one dollar for every ten dollars in deposits or we say large

must keep in reserve at least $1 for every $10 in deposits.

banks are required to have a reserve

Or we say, large banks are required

ratio of at least 10 percent but banks

to have a reserve ratio of at least 10%.

often have higher reserve ratios

But banks often have higher reserve ratios

depending upon how liquid that they want

depending upon how liquid that they want to be.

to be if a bank is worried that its

If a bank is worried

customers might withdraw most of their

that its customers might withdraw most of their money

money or bank loans are just not that profitable banks will hold more reserves

or if bank loans are just not that profitable, banks will hold more reserves.

so the reserve ratio can be greater than 10 percent and it can change over time

So the reserve ratio can be greater than 10% and it can change over time.

because of fractional reserve banking

Because of fractional reserve banking,

the banking system has a big effect on the supply of money let's see how

the banking system has a big effect on the supply of money.

suppose that your bank keeps 10% of your $1,000 deposit or $100 as reserved and

Let's see how. Suppose that your bank keeps 10% of your $1,000 deposit, or $100, as reserve.

suppose it lends out 90% or $900 say to

And suppose it lends out 90%, or $900,

Tyler who's interested in starting a business that $900 loan is credited to Tyler's checking account so now there's $1,900 in new deposits and since

say to Tyler, who's interested in starting a business. That $900 loan is credited to Tyler's checking account. So now there's $1,900 in new deposits.

checkable deposits our part of the money supply the money

And since checkable deposits are part of the money supply,

supply has increased and it doesn't stop

the money supply has increased.

And it doesn't stop there.

suppose that the bank holds 10% of Tyler's deposit in reserve and it lends

Suppose that the bank holds 10% of Tyler's deposit in reserve

out 90% or 810 dollars say to Janus now

and it lends out 90%, or $810, say, to Janet.

deposits have increased by two thousand seven hundred and ten dollars and

Now deposits have increased by $2,710.

suppose at ten percent of Janet's money

And suppose that 10% of Janet's money is held in reserve

is held in reserve and the rest is lent

and the rest is lent out.

out and so this process continues and as

And so this process continues.

the banks make more loans that increases

And as the banks make more loans --

the number of deposits which increases

that increases the number of deposits,

the number of loans which increases the

which increases the number of loans,

number of deposits so how much money do we ultimately end up with you can figure

which increases the number of deposits. So how much money do we ultimately end up with?

that out using what's called the money multiplier the money multiplier tells us

You can figure that out using what's called the "money multiplier."

how many dollars worth of deposits are

The money multiplier tells us how many dollars' worth of deposits are created

created with each additional dollar of reserves and the money multiplier is

with each additional dollar of reserves.

simple it's just 1 divided by the reserve ratio so if the reserve ratio is

And the money multiplier is simple. It's just 1 divided by the reserve ratio.

10 percent the money multiplier is 1

So if the reserve ratio is 10%,

divided by 0.1 or 10 and what that means

the money multiplier is 1 divided by 0.1, or 10.

is that one dollar in new reserves will

And what that means is that $1 in new reserves

ultimately lead through the multiplier

will ultimately lead, through the multiplier process,

process to ten dollars in additional

to $10 in additional money,

money as measured by say m1 or m2 now

as measured by, say, M1 or M2.

let's clarify our previous example and

Now let's clarify our previous example

why it was key that grandma was pulling

and why it was key that Grandma was pulling cash

cash from under her mattress if grandma

from under her mattress.

had instead given you a check for $1000

If Grandma had instead given you a check for $1,000,

she'd simply be transferring money from her account to yours which would not be

she'd simply be transferring money from her account to yours,

creating new reserves and so we wouldn't

which would not be creating new reserves --

see this multiplier effect and actually

and so we wouldn't see this multiplier effect.

the key player here is in grandma it's

And, actually, the key player here isn't Grandma --

Uncle Sam the Federal Reserve can with the click of a computer button create

it's Uncle Sam. The Federal Reserve can, with the click of a computer button,

new money new money which you can use to buy financial assets

create new money, new money, which it can use to buy financial assets,

thus injecting new reserves into the

thus injecting new reserves into the banking system.

banking system but the feds control over

But the Fed's control

the money supply process is indirect if

over the money-supply process is indirect.

banks hold the minimum amount of

If banks hold the minimum amount of required reserves --

required reserves 10% as we assumed

10%, as we assumed earlier --

earlier does the money multiplier will be close to 10 and if this is the case

then the money multiplier will be close to 10.

the Fed will have a lot of leverage to

And if this is the case, the Fed will have a lot of leverage

move m1 and m2 with a small change in

to move M1 and M2 with a small change in reserves.

reserves but in normal circumstances the

But in normal circumstances,

actual money multiplier is closer to 3

the actual money multiplier is closer to 3.

we'll remember banks can't hold less than 10% in reserve they could always

Well, remember, banks can't hold less than 10% in reserve.

hold more and the more banks hold and

They can always hold more.

reserve the lower the money multiplier

And the more banks hold in reserve, the lower the money multiplier.

so it's important to understand that the

So it's important to understand

money multiplier isn't a fixed number

that the money multiplier isn't a fixed number.

and the multiplier process isn't a mechanical relation

And the multiplier process isn't a mechanical relation.

here's another factor if Tyler had

Here's another factor.

stashed some of his loan under his

If Tyler had stashed some of his loan

mattress instead of depositing it into a

under his mattress instead of depositing it into a bank,

bank then his bank it wouldn't have had

then his bank --

the money to lend out his deposit and

it wouldn't have had the money to lend out his deposit,

the money multiplier would have been

and the money multiplier would have been lower.

lower and during a recession both of

And during a recession,

these things can happen at the same time

both of these things can happen at the same time.

banks may be reluctant to lend and

Banks may be reluctant to lend

they'll maybe put more cash and reserves

and they'll maybe put more cash in reserve.

plus people tend to hold more cash and

Plus people tend to hold more cash

not deposit their money in banks during

and not deposit their money in banks during a recession.

a recession both of these factors cause the money multiplier to fall so the

Both of these factors cause the money multiplier to fall.

Federal Reserve may have to push harder

So the Federal Reserve may have to push harder

to increase the money supply during a

to increase the money supply during a recession

recession than during a boom we're going

than during a boom.

to die further into how the Fed controls

We're going to dive further

the money supply and how that's changed

into how the Fed controls the money supply,

is the Great Recession in our next video

and how that's changed since the Great Recession in our next video.

you're on your way to mastering

[Narrator] You're on your way to mastering economics.

economics make sure this video sticks by taking a few practice questions or if

Make sure this video sticks by taking a few practice questions.

you're ready for more macroeconomics

Or, if you're ready for more macroeconomics,

click for the next video still here

click for the next video.

check out marginal revolution

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