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

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

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through fractional reserve banking.

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Let's imagine[br]that you graduate from college,

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

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

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and you deposit this cash[br]in your checking account.

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What does the bank do[br]with your money?

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Does it sit in a vault[br]with your name on it?

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No.

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

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Banks keep in reserve[br]only a fraction of your money --

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money they keep in cash[br]for the ATM,

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or to meet withdrawal demands.

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

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

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Well, large banks[br]in the United States

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must keep in reserve at least $1[br]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[br]of at least 10%.

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But banks often have[br]higher reserve ratios

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depending upon how liquid[br]that they want to be.

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If a bank is worried

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that its customers might withdraw[br]most of their money,

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or if bank loans are just[br]not that profitable,

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banks will hold more reserves.

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So the reserve ratio[br]can be greater than 10%,

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and it can change over time.

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Because of fractional [br]reserve banking,

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

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Let's see how.

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

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or $100, as reserve.

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And suppose it lends out[br]90%, or $900,

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say to Tyler, who's interested[br]in starting a business.

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

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

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and since checkable deposits[br]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%[br]of Tyler's deposit in reserve,

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and it lends out 90%, or $810,

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say to Janet.

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Now deposits have increased[br]by $2,710.

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And suppose that 10%[br]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[br]the number of deposits,

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which increases[br]the number of loans,

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which increases[br]the number of deposits.

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So how much money[br]do we ultimately end up with?

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You can figure that out

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using what's called[br]the "money multiplier."

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The money multiplier tells us

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how many dollars' worth[br]of deposits are created

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with each additional dollar[br]of reserves.

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And the money multiplier is simple.

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It's just 1 divided[br]by the reserve ratio.

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So if the reserve ratio is 10%,

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

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And what that means is that[br]$1 in new reserves

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will ultimately lead,[br]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[br]our previous example,

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and why it was key[br]that Grandma was pulling cash

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from under her mattress.

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

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

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which would not be creating[br]new reserves,

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and so we wouldn't see[br]this multiplier effect.

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

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it's Uncle Sam.

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

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create new money,

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new money which it can use[br]to buy financial assets,

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thus injecting new reserves[br]into the banking system.

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But the Fed's control

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over the money-supply process[br]is indirect.

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If banks hold the minimum amount[br]of required reserves --

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10% as we assumed earlier --

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then the money multiplier[br]will be close to 10.

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

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

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But in normal circumstances,

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the actual money multiplier[br]is closer to 3.

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How come?

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Well, remember, banks can't hold[br]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,[br]the lower the money multiplier.

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So it's important to understand

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that the money multiplier[br]isn't a fixed number,

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and the multiplier process[br]isn't a mechanical relation.

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Here's another factor.

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If Tyler had stashed[br]some of his loan

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under his mattress

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instead of depositing it[br]into a bank,

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then his bank --

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

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and the money multiplier[br]would have been lower.

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And during a recession,

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both of these things[br]can happen at the same time.

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Banks may be reluctant to lend,

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and they'll maybe[br]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[br]in banks during a recession.

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Both of these factors[br]cause the money multiplier to fall.

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So the Federal Reserve[br]may have to push harder

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to increase the money supply[br]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[br]controls the money supply,

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and how that's changed[br]since the Great Recession

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in our next video.

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

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

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Or, if you're ready[br]for more macroeconomics,

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click for the next video.

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