9:59:59.000,9:59:59.000 ♪ [music] ♪ 9:59:59.000,9:59:59.000 [Alex] Now that we know[br]how money is defined, 9:59:59.000,9:59:59.000 we'll learn how banks[br]can affect the supply of money 9:59:59.000,9:59:59.000 through fractional reserve banking. 9:59:59.000,9:59:59.000 Let's imagine[br]that you graduate from college, 9:59:59.000,9:59:59.000 and your grandma gives you[br]$1,000 in cash -- 9:59:59.000,9:59:59.000 that she's been saving[br]under her mattress since the 1970s -- 9:59:59.000,9:59:59.000 and you deposit this cash[br]in your checking account. 9:59:59.000,9:59:59.000 What does the bank do[br]with your money? 9:59:59.000,9:59:59.000 Does it sit in a vault[br]with your name on it? 9:59:59.000,9:59:59.000 No. 9:59:59.000,9:59:59.000 Banks lend most of your money[br]to people who want to borrow. 9:59:59.000,9:59:59.000 Banks keep in reserve[br]only a fraction of your money -- 9:59:59.000,9:59:59.000 money they keep in cash[br]for the ATM, 9:59:59.000,9:59:59.000 or to meet withdrawal demands. 9:59:59.000,9:59:59.000 This is why this system is known[br]as "fractional reserve banking." 9:59:59.000,9:59:59.000 So what fraction of your deposit[br]do banks keep in reserve? 9:59:59.000,9:59:59.000 Well, large banks[br]in the United States 9:59:59.000,9:59:59.000 must keep in reserve at least $1[br]for every $10 in deposits, 9:59:59.000,9:59:59.000 or we say large banks are required 9:59:59.000,9:59:59.000 to have a reserve ratio[br]of at least 10%. 9:59:59.000,9:59:59.000 But banks often have[br]higher reserve ratios 9:59:59.000,9:59:59.000 depending upon how liquid[br]that they want to be. 9:59:59.000,9:59:59.000 If a bank is worried 9:59:59.000,9:59:59.000 that its customers might withdraw[br]most of their money, 9:59:59.000,9:59:59.000 or if bank loans are just[br]not that profitable, 9:59:59.000,9:59:59.000 banks will hold more reserves. 9:59:59.000,9:59:59.000 So the reserve ratio[br]can be greater than 10% 9:59:59.000,9:59:59.000 and it can change over time. 9:59:59.000,9:59:59.000 Because of[br]fractional reserve banking 9:59:59.000,9:59:59.000 the banking system has a big effect[br]on the supply of money. 9:59:59.000,9:59:59.000 Let's see how. 9:59:59.000,9:59:59.000 Suppose that your bank keeps 10%[br]of your $1,000 deposit, 9:59:59.000,9:59:59.000 or $100 as reserve. 9:59:59.000,9:59:59.000 And suppose it lends out 90%,[br]or $900, say to Tyler, 9:59:59.000,9:59:59.000 who's interested[br]in starting a business. 9:59:59.000,9:59:59.000 That $900 loan is credited[br]to Tyler's checking account. 9:59:59.000,9:59:59.000 So now there's $1,900[br]in new deposits, 9:59:59.000,9:59:59.000 and since checkable deposits[br]are part of the money supply, 9:59:59.000,9:59:59.000 the money supply has increased. 9:59:59.000,9:59:59.000 And it doesn't stop there. 9:59:59.000,9:59:59.000 Suppose that the bank holds 10%[br]of Tyler's deposit in reserve, 9:59:59.000,9:59:59.000 and it lends out 90%, or $810,[br]say to Janet. 9:59:59.000,9:59:59.000 Now deposits have increased[br]by $2,710. 9:59:59.000,9:59:59.000 And suppose that 10%[br]of Janet's money is held in reserve, 9:59:59.000,9:59:59.000 and the rest is lent out. 9:59:59.000,9:59:59.000 And so this process continues. 9:59:59.000,9:59:59.000 And as the banks make more loans, 9:59:59.000,9:59:59.000 that increases[br]the number of deposits, 9:59:59.000,9:59:59.000 which increases[br]the number of loans, 9:59:59.000,9:59:59.000 which increases[br]the number of deposits. 9:59:59.000,9:59:59.000 So how much money[br]do we ultimately end up with? 9:59:59.000,9:59:59.000 You can figure that out 9:59:59.000,9:59:59.000 using what's called[br]the "money multiplier." 9:59:59.000,9:59:59.000 The money multiplier tells us 9:59:59.000,9:59:59.000 how many dollar's worth[br]of deposits are created 9:59:59.000,9:59:59.000 with each additional dollar[br]of reserves. 9:59:59.000,9:59:59.000 And the money multiplier is simple. 9:59:59.000,9:59:59.000 It's just 1 divided[br]by the reserve ratio. 9:59:59.000,9:59:59.000 So if the reserve ratio is 10%, 9:59:59.000,9:59:59.000 the money multiplier is[br]1 divided by 0.1, or 10. 9:59:59.000,9:59:59.000 And what that means is that[br]$1 in new reserves 9:59:59.000,9:59:59.000 will ultimate lead,[br]through the multiplier process, 9:59:59.000,9:59:59.000 to $10 in additional money 9:59:59.000,9:59:59.000 as measured by, say, M1 or M2. 9:59:59.000,9:59:59.000 Now let's clarify[br]our previous example, 9:59:59.000,9:59:59.000 and why it was key that Grandma[br]was pulling cash 9:59:59.000,9:59:59.000 from under her mattress. 9:59:59.000,9:59:59.000 If Grandma had instead[br]given you a check for $1,000, 9:59:59.000,9:59:59.000 she'd simply be transferring money[br]from her account to yours -- 9:59:59.000,9:59:59.000 which would not be creating[br]new reserves, 9:59:59.000,9:59:59.000 and so we wouldn't see[br]this multiplier effect. 9:59:59.000,9:59:59.000 And, actually, the key player here[br]isn't Grandma -- 9:59:59.000,9:59:59.000 it's Uncle Sam, the Federal Reserve. 9:59:59.000,9:59:59.000 And with the click[br]of a computer button 9:59:59.000,9:59:59.000 create new money, 9:59:59.000,9:59:59.000 new money which you can use[br]to buy financial assets, 9:59:59.000,9:59:59.000 thus injecting new reserves[br]into the banking system. 9:59:59.000,9:59:59.000 But the Feds' control 9:59:59.000,9:59:59.000 over the money-supply process[br]is indirect. 9:59:59.000,9:59:59.000 If banks hold the minimum amount[br]of required reserves -- 9:59:59.000,9:59:59.000 10% as we assumed earlier -- 9:59:59.000,9:59:59.000 then the money multiplier[br]will be close to 10. 9:59:59.000,9:59:59.000 And if this is the case,[br]the Fed will have a lot of leverage 9:59:59.000,9:59:59.000 to move M1 and M2[br]with a small change in reserves. 9:59:59.000,9:59:59.000 But in normal circumstances, 9:59:59.000,9:59:59.000 the actual money multiplier[br]is closer to 3. 9:59:59.000,9:59:59.000 How come? 9:59:59.000,9:59:59.000 Well, remember, banks can't hold[br]less than 10% in reserve. 9:59:59.000,9:59:59.000 They can always hold more. 9:59:59.000,9:59:59.000 And the more banks hold in reserve,[br]the lower the money multiplier. 9:59:59.000,9:59:59.000 So it's important to understand 9:59:59.000,9:59:59.000 that the money multiplier[br]isn't a fixed number, 9:59:59.000,9:59:59.000 and the multiplier process[br]isn't a mechanical relation. 9:59:59.000,9:59:59.000 Here's another factor. 9:59:59.000,9:59:59.000 If Tyler had stashed[br]some of his loan 9:59:59.000,9:59:59.000 under his mattress, 9:59:59.000,9:59:59.000 instead of depositing it[br]into a bank, then his bank -- 9:59:59.000,9:59:59.000 it wouldn't have had the money[br]to lend out his deposit, 9:59:59.000,9:59:59.000 and the money multiplier[br]would have been lower. 9:59:59.000,9:59:59.000 And during a recession, 9:59:59.000,9:59:59.000 both of these things[br]can happen at the same time. 9:59:59.000,9:59:59.000 Banks may be reluctant to lend, 9:59:59.000,9:59:59.000 and they'll maybe[br]put more cash in reserve, 9:59:59.000,9:59:59.000 plus people tend to hold more cash, 9:59:59.000,9:59:59.000 and not deposit their money[br]in banks during a recession. 9:59:59.000,9:59:59.000 Both of these factors[br]cause the money multiplier to fall. 9:59:59.000,9:59:59.000 So the Federal Reserve[br]may have to push harder 9:59:59.000,9:59:59.000 to increase the money supply 9:59:59.000,9:59:59.000 during a recession[br]than during a boom. 9:59:59.000,9:59:59.000 We're going to dive further 9:59:59.000,9:59:59.000 into how the Fed[br]controls the money supply, 9:59:59.000,9:59:59.000 and how that's changed[br]since the Great Recession 9:59:59.000,9:59:59.000 in our next video. 9:59:59.000,9:59:59.000 [Narrator] You're on your way[br]to mastering economics. 9:59:59.000,9:59:59.000 Make sure this video sticks[br]by taking a few practice questions. 9:59:59.000,9:59:59.000 Or, if you're ready[br]for more macroeconomics, 9:59:59.000,9:59:59.000 click for the next video. 9:59:59.000,9:59:59.000 Still here? 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