1
00:00:00,117 --> 00:00:03,788
♪ [music] ♪

2
00:00:16,074 --> 00:00:18,696
[Alex] Now that we know
how money is defined,

3
00:00:18,696 --> 00:00:22,878
we'll learn how banks
can affect the supply of money

4
00:00:22,878 --> 00:00:25,397
through fractional reserve banking.

5
00:00:25,881 --> 00:00:28,467
Let's imagine
that you graduate from college

6
00:00:28,467 --> 00:00:31,980
and your grandma gives you
$1,000 in cash --

7
00:00:31,980 --> 00:00:37,142
that she's been saving
under her mattress since the 1970s.

8
00:00:37,142 --> 00:00:40,348
And you deposit this cash
in your checking account.

9
00:00:40,348 --> 00:00:42,223
What does the bank do
with your money?

10
00:00:42,613 --> 00:00:45,451
Does it sit in a vault
with your name on it?

11
00:00:45,802 --> 00:00:46,821
No.

12
00:00:47,251 --> 00:00:52,289
Banks lend most of your money
to people who want to borrow.

13
00:00:52,759 --> 00:00:57,634
Banks keep in reserve
only a fraction of your money --

14
00:00:57,634 --> 00:01:00,396
money they keep in cash
for the ATM

15
00:01:00,396 --> 00:01:02,681
or to meet withdrawal demands.

16
00:01:02,681 --> 00:01:07,402
This is why this system is known
as "fractional reserve banking."

17
00:01:07,730 --> 00:01:11,131
So what fraction of your deposit
do banks keep in reserve?

18
00:01:11,982 --> 00:01:14,417
Well, large banks
in the United States

19
00:01:14,417 --> 00:01:20,118
must keep in reserve at least $1
for every $10 in deposits.

20
00:01:20,759 --> 00:01:23,779
Or we say, large banks are required

21
00:01:23,779 --> 00:01:27,998
to have a reserve ratio
of at least 10%.

22
00:01:27,998 --> 00:01:31,584
But banks often have
higher reserve ratios

23
00:01:31,584 --> 00:01:34,942
depending upon how liquid
that they want to be.

24
00:01:34,942 --> 00:01:36,158
If a bank is worried

25
00:01:36,158 --> 00:01:39,282
that its customers might withdraw
most of their money

26
00:01:39,282 --> 00:01:42,492
or if bank loans are just
not that profitable,

27
00:01:42,989 --> 00:01:45,647
banks will hold more reserves.

28
00:01:45,874 --> 00:01:49,183
So the reserve ratio
can be greater than 10%

29
00:01:49,762 --> 00:01:52,214
and it can change over time.

30
00:01:52,214 --> 00:01:54,496
Because of fractional 
reserve banking,

31
00:01:54,496 --> 00:01:58,190
the banking system has a big effect
on the supply of money.

32
00:01:58,190 --> 00:01:59,496
Let's see how.

33
00:01:59,496 --> 00:02:04,332
Suppose that your bank keeps 10%
of your $1,000 deposit,

34
00:02:04,332 --> 00:02:06,884
or $100, as reserve.

35
00:02:07,335 --> 00:02:12,832
And suppose it lends out
90%, or $900,

36
00:02:12,832 --> 00:02:15,939
say to Tyler, who's interested
in starting a business.

37
00:02:16,560 --> 00:02:21,990
That $900 loan is credited
to Tyler's checking account.

38
00:02:22,459 --> 00:02:27,458
So now there's $1,900
in new deposits.

39
00:02:27,458 --> 00:02:31,855
And since checkable deposits
are part of the money supply,

40
00:02:31,855 --> 00:02:34,716
the money supply has increased.

41
00:02:35,290 --> 00:02:36,966
And it doesn't stop there.

42
00:02:36,966 --> 00:02:41,786
Suppose that the bank holds 10%
of Tyler's deposit in reserve

43
00:02:41,786 --> 00:02:46,992
and it lends out 90%, or $810,

44
00:02:46,992 --> 00:02:48,222
say, to Janet.

45
00:02:49,084 --> 00:02:54,003
Now deposits have increased
by $2,710.

46
00:02:54,003 --> 00:02:57,352
And suppose that 10%
of Janet's money is held in reserve

47
00:02:57,352 --> 00:02:59,050
and the rest is lent out.

48
00:02:59,333 --> 00:03:01,484
And so this process continues.

49
00:03:01,952 --> 00:03:04,610
And as the banks make more loans --

50
00:03:04,610 --> 00:03:06,779
that increases
the number of deposits,

51
00:03:06,779 --> 00:03:08,283
which increases
the number of loans,

52
00:03:08,283 --> 00:03:10,251
which increases
the number of deposits.

53
00:03:10,434 --> 00:03:13,967
So how much money
do we ultimately end up with?

54
00:03:14,400 --> 00:03:15,947
You can figure that out

55
00:03:15,947 --> 00:03:19,124
using what's called
the "money multiplier."

56
00:03:19,427 --> 00:03:21,068
The money multiplier tells us

57
00:03:21,068 --> 00:03:24,620
how many dollars' worth
of deposits are created

58
00:03:24,620 --> 00:03:27,637
with each additional dollar
of reserves.

59
00:03:28,149 --> 00:03:30,271
And the money multiplier is simple.

60
00:03:30,671 --> 00:03:34,815
It's just 1 divided
by the reserve ratio.

61
00:03:34,815 --> 00:03:37,000
So if the reserve ratio is 10%,

62
00:03:37,414 --> 00:03:42,011
the money multiplier is
1 divided by 0.1, or 10.

63
00:03:42,295 --> 00:03:47,621
And what that means is that
$1 in new reserves

64
00:03:47,621 --> 00:03:52,019
will ultimately lead,
through the multiplier process,

65
00:03:52,019 --> 00:03:55,718
to $10 in additional money,

66
00:03:55,718 --> 00:03:59,015
as measured by, say, M1 or M2.

67
00:03:59,015 --> 00:04:02,013
Now let's clarify
our previous example

68
00:04:02,013 --> 00:04:06,259
and why it was key
that Grandma was pulling cash

69
00:04:06,259 --> 00:04:07,912
from under her mattress.

70
00:04:07,912 --> 00:04:11,964
If Grandma had instead
given you a check for $1,000,

71
00:04:11,964 --> 00:04:15,682
she'd simply be transferring money
from her account to yours,

72
00:04:15,682 --> 00:04:19,567
which would not be creating
new reserves --

73
00:04:19,567 --> 00:04:22,368
and so we wouldn't see
this multiplier effect.

74
00:04:22,368 --> 00:04:26,596
And, actually, the key player here
isn't Grandma --

75
00:04:26,596 --> 00:04:28,207
it's Uncle Sam.

76
00:04:28,586 --> 00:04:32,787
The Federal Reserve can,
with the click of a computer button,

77
00:04:32,787 --> 00:04:34,757
create new money,

78
00:04:34,757 --> 00:04:39,515
new money, which it can use
to buy financial assets,

79
00:04:39,515 --> 00:04:44,598
thus injecting new reserves
into the banking system.

80
00:04:44,849 --> 00:04:46,034
But the Fed's control

81
00:04:46,034 --> 00:04:48,839
over the money-supply process
is indirect.

82
00:04:49,471 --> 00:04:52,528
If banks hold the minimum amount
of required reserves --

83
00:04:52,528 --> 00:04:54,998
10%, as we assumed earlier --

84
00:04:54,998 --> 00:04:57,902
then the money multiplier
will be close to 10.

85
00:04:57,902 --> 00:05:02,014
And if this is the case,
the Fed will have a lot of leverage

86
00:05:02,014 --> 00:05:07,223
to move M1 and M2
with a small change in reserves.

87
00:05:07,223 --> 00:05:09,591
But in normal circumstances,

88
00:05:09,591 --> 00:05:12,544
the actual money multiplier
is closer to 3.

89
00:05:13,182 --> 00:05:14,254
How come?

90
00:05:14,602 --> 00:05:19,566
Well, remember, banks can't hold
less than 10% in reserve.

91
00:05:19,937 --> 00:05:21,744
They can always hold more.

92
00:05:22,104 --> 00:05:26,871
And the more banks hold in reserve,
the lower the money multiplier.

93
00:05:26,871 --> 00:05:28,607
So it's important to understand

94
00:05:28,607 --> 00:05:32,274
that the money multiplier
isn't a fixed number.

95
00:05:32,274 --> 00:05:36,996
And the multiplier process
isn't a mechanical relation.

96
00:05:36,996 --> 00:05:38,550
Here's another factor.

97
00:05:39,067 --> 00:05:41,899
If Tyler had stashed
some of his loan

98
00:05:41,899 --> 00:05:43,748
under his mattress

99
00:05:43,748 --> 00:05:46,870
instead of depositing it
into a bank,

100
00:05:46,870 --> 00:05:48,292
then his bank --

101
00:05:48,292 --> 00:05:51,568
it wouldn't have had the money
to lend out his deposit,

102
00:05:51,568 --> 00:05:54,271
and the money multiplier
would have been lower.

103
00:05:54,271 --> 00:05:55,814
And during a recession,

104
00:05:55,814 --> 00:05:58,420
both of these things
can happen at the same time.

105
00:05:58,883 --> 00:06:01,230
Banks may be reluctant to lend

106
00:06:01,230 --> 00:06:03,910
and they'll maybe
put more cash in reserve.

107
00:06:04,310 --> 00:06:06,547
Plus people tend to hold more cash

108
00:06:06,547 --> 00:06:10,082
and not deposit their money
in banks during a recession.

109
00:06:10,082 --> 00:06:13,852
Both of these factors
cause the money multiplier to fall.

110
00:06:14,844 --> 00:06:18,668
So the Federal Reserve
may have to push harder

111
00:06:18,668 --> 00:06:22,083
to increase the money supply
during a recession

112
00:06:22,083 --> 00:06:23,613
than during a boom.

113
00:06:23,961 --> 00:06:25,279
We're going to dive further

114
00:06:25,279 --> 00:06:27,605
into how the Fed
controls the money supply,

115
00:06:27,605 --> 00:06:30,653
and how that's changed
since the Great Recession

116
00:06:30,653 --> 00:06:31,966
in our next video.

117
00:06:33,425 --> 00:06:35,505
[Narrator] You're on your way
to mastering economics.

118
00:06:35,505 --> 00:06:38,982
Make sure this video sticks
by taking a few practice questions.

119
00:06:38,982 --> 00:06:41,123
Or, if you're ready
for more macroeconomics,

120
00:06:41,123 --> 00:06:42,539
click for the next video.

121
00:06:44,397 --> 00:06:45,398
Still here?

122
00:06:45,398 --> 00:06:48,492
Check out Marginal Revolution
University's other popular videos.

123
00:06:48,754 --> 00:06:51,274
♪ [music] ♪