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The Money Multiplier

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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 the 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,
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    say to Tyler, 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,
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    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 ultimately 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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    Still here?
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    Check out Marginal Revolution
    University's other popular videos.
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    ♪ [music] ♪
Title:
The Money Multiplier
Description:

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Video Language:
English
Team:
Marginal Revolution University
Project:
Macro
Duration:
06:56
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