The Money Multiplier

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

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

through fractional reserve banking.

Let's imagine
that you graduate from college

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

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

And you deposit this cash
in your checking account.

What does the bank do
with your money?

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

No.

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

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

money they keep in cash
for the ATM

or to meet withdrawal demands.

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

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

Well, large banks
in the United States

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

Or we say, large banks are required

to have a reserve ratio
of at least 10%.

But banks often have
higher reserve ratios

depending upon how liquid
that they want to be.

If a bank is worried

that its customers might withdraw
most of their money

or if bank loans are just
not that profitable,

banks will hold more reserves.

So the reserve ratio
can be greater than 10%

and it can change over time.

Because of fractional
reserve banking,

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

Let's see how.

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

or $100, as reserve.

And suppose it lends out
90%, or $900,

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

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

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

And since checkable deposits
are part of the money supply,

the money supply has increased.

And it doesn't stop there.

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

and it lends out 90%, or $810,

say, to Janet.

Now deposits have increased
by $2,710.

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

and the rest is lent out.

And so this process continues.

And as the banks make more loans --

that increases
the number of deposits,

which increases
the number of loans,

which increases
the number of deposits.

So how much money
do we ultimately end up with?

You can figure that out

using what's called
the "money multiplier."

The money multiplier tells us

how many dollars' worth
of deposits are created

with each additional dollar
of reserves.

And the money multiplier is simple.

It's just 1 divided
by the reserve ratio.

So if the reserve ratio is 10%,

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

And what that means is that
$1 in new reserves

will ultimately lead,
through the multiplier process,

to $10 in additional money,

as measured by, say, M1 or M2.

Now let's clarify
our previous example

and why it was key
that Grandma was pulling cash

from under her mattress.

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

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

which would not be creating
new reserves --

and so we wouldn't see
this multiplier effect.

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

it's Uncle Sam.

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

create new money,

new money, which it can use
to buy financial assets,

thus injecting new reserves
into the banking system.

But the Fed's control

over the money-supply process
is indirect.

If banks hold the minimum amount
of required reserves --

10%, as we assumed earlier --

then the money multiplier
will be close to 10.

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

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

But in normal circumstances,

the actual money multiplier
is closer to 3.

How come?

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

They can always hold more.

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

So it's important to understand

that the money multiplier
isn't a fixed number.

And the multiplier process
isn't a mechanical relation.

Here's another factor.

If Tyler had stashed
some of his loan

under his mattress

instead of depositing it
into a bank,

then his bank --

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

and the money multiplier
would have been lower.

And during a recession,

both of these things
can happen at the same time.

Banks may be reluctant to lend

and they'll maybe
put more cash in reserve.

Plus people tend to hold more cash

and not deposit their money
in banks during a recession.

Both of these factors
cause the money multiplier to fall.

So the Federal Reserve
may have to push harder

to increase the money supply
during a recession

than during a boom.

We're going to dive further

into how the Fed
controls the money supply,

and how that's changed
since the Great Recession

in our next video.

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

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by taking a few practice questions.

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click for the next video.

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