1
99:59:59,999 --> 99:59:59,999
♪ [music] ♪

2
99:59:59,999 --> 99:59:59,999
[Alex] Now that we know
how money is defined,

3
99:59:59,999 --> 99:59:59,999
we'll learn how banks
can affect the supply of money

4
99:59:59,999 --> 99:59:59,999
through fractional reserve banking.

5
99:59:59,999 --> 99:59:59,999
Let's imagine
that you graduate from college,

6
99:59:59,999 --> 99:59:59,999
and your grandma gives you
$1,000 in cash --

7
99:59:59,999 --> 99:59:59,999
that she's been saving
under her mattress since the 1970s --

8
99:59:59,999 --> 99:59:59,999
and you deposit this cash
in your checking account.

9
99:59:59,999 --> 99:59:59,999
What does the bank do
with your money?

10
99:59:59,999 --> 99:59:59,999
Does it sit in a vault
with your name on it?

11
99:59:59,999 --> 99:59:59,999
No.

12
99:59:59,999 --> 99:59:59,999
Banks lend most of your money
to people who want to borrow.

13
99:59:59,999 --> 99:59:59,999
Banks keep in reserve
only a fraction of your money --

14
99:59:59,999 --> 99:59:59,999
money they keep in cash
for the ATM,

15
99:59:59,999 --> 99:59:59,999
or to meet withdrawal demands.

16
99:59:59,999 --> 99:59:59,999
This is why this system is known
as "fractional reserve banking."

17
99:59:59,999 --> 99:59:59,999
So what fraction of your deposit
do banks keep in reserve?

18
99:59:59,999 --> 99:59:59,999
Well, large banks
in the United States

19
99:59:59,999 --> 99:59:59,999
must keep in reserve at least $1
for every $10 in deposits,

20
99:59:59,999 --> 99:59:59,999
or we say large banks are required

21
99:59:59,999 --> 99:59:59,999
to have a reserve ratio
of at least 10%.

22
99:59:59,999 --> 99:59:59,999
But banks often have
higher reserve ratios

23
99:59:59,999 --> 99:59:59,999
depending upon how liquid
that they want to be.

24
99:59:59,999 --> 99:59:59,999
If a bank is worried

25
99:59:59,999 --> 99:59:59,999
that its customers might withdraw
most of their money,

26
99:59:59,999 --> 99:59:59,999
or if bank loans are just
not that profitable,

27
99:59:59,999 --> 99:59:59,999
banks will hold more reserves.

28
99:59:59,999 --> 99:59:59,999
So the reserve ratio
can be greater than 10%

29
99:59:59,999 --> 99:59:59,999
and it can change over time.

30
99:59:59,999 --> 99:59:59,999
Because of
fractional reserve banking

31
99:59:59,999 --> 99:59:59,999
the banking system has a big effect
on the supply of money.

32
99:59:59,999 --> 99:59:59,999
Let's see how.

33
99:59:59,999 --> 99:59:59,999
Suppose that your bank keeps 10%
of your $1,000 deposit,

34
99:59:59,999 --> 99:59:59,999
or $100 as reserve.

35
99:59:59,999 --> 99:59:59,999
And suppose it lends out 90%,
or $900, say to Tyler,

36
99:59:59,999 --> 99:59:59,999
who's interested
in starting a business.

37
99:59:59,999 --> 99:59:59,999
That $900 loan is credited
to Tyler's checking account.

38
99:59:59,999 --> 99:59:59,999
So now there's $1,900
in new deposits,

39
99:59:59,999 --> 99:59:59,999
and since checkable deposits
are part of the money supply,

40
99:59:59,999 --> 99:59:59,999
the money supply has increased.

41
99:59:59,999 --> 99:59:59,999
And it doesn't stop there.

42
99:59:59,999 --> 99:59:59,999
Suppose that the bank holds 10%
of Tyler's deposit in reserve,

43
99:59:59,999 --> 99:59:59,999
and it lends out 90%, or $810,
say to Janet.

44
99:59:59,999 --> 99:59:59,999
Now deposits have increased
by $2,710.

45
99:59:59,999 --> 99:59:59,999
And suppose that 10%
of Janet's money is held in reserve,

46
99:59:59,999 --> 99:59:59,999
and the rest is lent out.

47
99:59:59,999 --> 99:59:59,999
And so this process continues.

48
99:59:59,999 --> 99:59:59,999
And as the banks make more loans,

49
99:59:59,999 --> 99:59:59,999
that increases
the number of deposits,

50
99:59:59,999 --> 99:59:59,999
which increases
the number of loans,

51
99:59:59,999 --> 99:59:59,999
which increases
the number of deposits.

52
99:59:59,999 --> 99:59:59,999
So how much money
do we ultimately end up with?

53
99:59:59,999 --> 99:59:59,999
You can figure that out

54
99:59:59,999 --> 99:59:59,999
using what's called
the "money multiplier."

55
99:59:59,999 --> 99:59:59,999
The money multiplier tells us

56
99:59:59,999 --> 99:59:59,999
how many dollar's worth
of deposits are created

57
99:59:59,999 --> 99:59:59,999
with each additional dollar
of reserves.

58
99:59:59,999 --> 99:59:59,999
And the money multiplier is simple.

59
99:59:59,999 --> 99:59:59,999
It's just 1 divided
by the reserve ratio.

60
99:59:59,999 --> 99:59:59,999
So if the reserve ratio is 10%,

61
99:59:59,999 --> 99:59:59,999
the money multiplier is
1 divided by 0.1, or 10.

62
99:59:59,999 --> 99:59:59,999
And what that means is that
$1 in new reserves

63
99:59:59,999 --> 99:59:59,999
will ultimate lead,
through the multiplier process,

64
99:59:59,999 --> 99:59:59,999
to $10 in additional money

65
99:59:59,999 --> 99:59:59,999
as measured by, say, M1 or M2.

66
99:59:59,999 --> 99:59:59,999
Now let's clarify
our previous example,

67
99:59:59,999 --> 99:59:59,999
and why it was key that Grandma
was pulling cash

68
99:59:59,999 --> 99:59:59,999
from under her mattress.

69
99:59:59,999 --> 99:59:59,999
If Grandma had instead
given you a check for $1,000,

70
99:59:59,999 --> 99:59:59,999
she'd simply be transferring money
from her account to yours --

71
99:59:59,999 --> 99:59:59,999
which would not be creating
new reserves,

72
99:59:59,999 --> 99:59:59,999
and so we wouldn't see
this multiplier effect.

73
99:59:59,999 --> 99:59:59,999
And, actually, the key player here
isn't Grandma --

74
99:59:59,999 --> 99:59:59,999
it's Uncle Sam, the Federal Reserve.

75
99:59:59,999 --> 99:59:59,999
And with the click
of a computer button

76
99:59:59,999 --> 99:59:59,999
create new money,

77
99:59:59,999 --> 99:59:59,999
new money which you can use
to buy financial assets,

78
99:59:59,999 --> 99:59:59,999
thus injecting new reserves
into the banking system.

79
99:59:59,999 --> 99:59:59,999
But the Feds' control

80
99:59:59,999 --> 99:59:59,999
over the money-supply process
is indirect.

81
99:59:59,999 --> 99:59:59,999
If banks hold the minimum amount
of required reserves --

82
99:59:59,999 --> 99:59:59,999
10% as we assumed earlier --

83
99:59:59,999 --> 99:59:59,999
then the money multiplier
will be close to 10.

84
99:59:59,999 --> 99:59:59,999
And if this is the case,
the Fed will have a lot of leverage

85
99:59:59,999 --> 99:59:59,999
to move M1 and M2
with a small change in reserves.

86
99:59:59,999 --> 99:59:59,999
But in normal circumstances,

87
99:59:59,999 --> 99:59:59,999
the actual money multiplier
is closer to 3.

88
99:59:59,999 --> 99:59:59,999
How come?

89
99:59:59,999 --> 99:59:59,999
Well, remember, banks can't hold
less than 10% in reserve.

90
99:59:59,999 --> 99:59:59,999
They can always hold more.

91
99:59:59,999 --> 99:59:59,999
And the more banks hold in reserve,
the lower the money multiplier.

92
99:59:59,999 --> 99:59:59,999
So it's important to understand

93
99:59:59,999 --> 99:59:59,999
that the money multiplier
isn't a fixed number,

94
99:59:59,999 --> 99:59:59,999
and the multiplier process
isn't a mechanical relation.

95
99:59:59,999 --> 99:59:59,999
Here's another factor.

96
99:59:59,999 --> 99:59:59,999
If Tyler had stashed
some of his loan

97
99:59:59,999 --> 99:59:59,999
under his mattress,

98
99:59:59,999 --> 99:59:59,999
instead of depositing it
into a bank, then his bank --

99
99:59:59,999 --> 99:59:59,999
it wouldn't have had the money
to lend out his deposit,

100
99:59:59,999 --> 99:59:59,999
and the money multiplier
would have been lower.

101
99:59:59,999 --> 99:59:59,999
And during a recession,

102
99:59:59,999 --> 99:59:59,999
both of these things
can happen at the same time.

103
99:59:59,999 --> 99:59:59,999
Banks may be reluctant to lend,

104
99:59:59,999 --> 99:59:59,999
and they'll maybe
put more cash in reserve,

105
99:59:59,999 --> 99:59:59,999
plus people tend to hold more cash,

106
99:59:59,999 --> 99:59:59,999
and not deposit their money
in banks during a recession.

107
99:59:59,999 --> 99:59:59,999
Both of these factors
cause the money multiplier to fall.

108
99:59:59,999 --> 99:59:59,999
So the Federal Reserve
may have to push harder

109
99:59:59,999 --> 99:59:59,999
to increase the money supply

110
99:59:59,999 --> 99:59:59,999
during a recession
than during a boom.

111
99:59:59,999 --> 99:59:59,999
We're going to dive further

112
99:59:59,999 --> 99:59:59,999
into how the Fed
controls the money supply,

113
99:59:59,999 --> 99:59:59,999
and how that's changed
since the Great Recession

114
99:59:59,999 --> 99:59:59,999
in our next video.

115
99:59:59,999 --> 99:59:59,999
[Narrator] You're on your way
to mastering economics.

116
99:59:59,999 --> 99:59:59,999
Make sure this video sticks
by taking a few practice questions.

117
99:59:59,999 --> 99:59:59,999
Or, if you're ready
for more macroeconomics,

118
99:59:59,999 --> 99:59:59,999
click for the next video.

119
99:59:59,999 --> 99:59:59,999
Still here?

120
99:59:59,999 --> 99:59:59,999
Check out Marginal Revolution
University's other popular videos.

121
99:59:59,999 --> 99:59:59,999
♪ [music] ♪