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♪ [music] ♪

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

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

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through fractional reserve banking.

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Let's imagine
that you graduate from college,

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

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

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and you deposit this cash
in your checking account.

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What does the bank do
with your money?

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

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No.

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Banks lend most of your money
to people who want to borrow.

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

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money they keep in cash
for the ATM,

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or to meet withdrawal demands.

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

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

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Well, large banks
in the United States

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

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or we say large banks are required

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to have a reserve ratio
of at least 10%.

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But banks often have
higher reserve ratios

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depending upon how liquid
that they want to be.

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If a bank is worried

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that its customers might withdraw
most of their money,

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or if bank loans are just
not that profitable,

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banks will hold more reserves.

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So the reserve ratio
can be greater than 10%

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and it can change over time.

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Because of
fractional reserve banking

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

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Let's see how.

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Suppose that your bank keeps 10%
of your $1,000 deposit,

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or $100 as reserve.

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And suppose it lends out 90%,
or $900, say to Tyler,

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who's interested
in starting a business.

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That $900 loan is credited
to Tyler's checking account.

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So now there's $1,900
in new deposits,

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and since checkable deposits
are part of the money supply,

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the money supply has increased.

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And it doesn't stop there.

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

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

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Now deposits have increased
by $2,710.

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

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and the rest is lent out.

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And so this process continues.

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And as the banks make more loans,

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that increases
the number of deposits,

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which increases
the number of loans,

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which increases
the number of deposits.

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So how much money
do we ultimately end up with?

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You can figure that out

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using what's called
the "money multiplier."

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The money multiplier tells us

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how many dollar's worth
of deposits are created

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with each additional dollar
of reserves.

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And the money multiplier is simple.

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It's just 1 divided
by the reserve ratio.

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So if the reserve ratio is 10%,

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

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And what that means is that
$1 in new reserves

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will ultimate lead,
through the multiplier process,

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to $10 in additional money

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as measured by, say, M1 or M2.

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Now let's clarify
our previous example,

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and why it was key that Grandma
was pulling cash

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from under her mattress.

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

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

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which would not be creating
new reserves,

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and so we wouldn't see
this multiplier effect.

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

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it's Uncle Sam.

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The Federal Reserve can,
with the click of a computer button,

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create new money,

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new money which it can use
to buy financial assets,

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thus injecting new reserves
into the banking system.

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But the Feds' control

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over the money-supply process
is indirect.

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If banks hold the minimum amount
of required reserves --

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10% as we assumed earlier --

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then the money multiplier
will be close to 10.

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

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

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But in normal circumstances,

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the actual money multiplier
is closer to 3.

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How come?

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

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They can always hold more.

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

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So it's important to understand

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that the money multiplier
isn't a fixed number,

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and the multiplier process
isn't a mechanical relation.

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Here's another factor.

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If Tyler had stashed
some of his loan

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under his mattress

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instead of depositing it
into a bank,

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then his bank --

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

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and the money multiplier
would have been lower.

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And during a recession,

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both of these things
can happen at the same time.

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Banks may be reluctant to lend,

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and they'll maybe
put more cash in reserve,

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plus people tend to hold more cash,

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and not deposit their money
in banks during a recession.

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Both of these factors
cause the money multiplier to fall.

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So the Federal Reserve
may have to push harder

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to increase the money supply
during a recession

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than during a boom.

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We're going to dive further

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into how the Fed
controls the money supply,

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and how that's changed
since the Great Recession

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in our next video.

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

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

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Or, if you're ready
for more macroeconomics,

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click for the next video.

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♪ [music] ♪