♪ [music] ♪ [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. Make sure this video sticks
by taking a few practice questions. Or, if you’re ready
for more macroeconomics, click for the next video. Still here? Check out Marginal Revolution
University’s other popular videos. ♪ [music] ♪

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55 thoughts on “The Money Multiplier”

  1. http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf , what about this?

  2. The Fed has nothing to do with uncle Sam. It's a private bank that has the exclusive right to create money out of thin air. It is accountable to nobody.

  3. Bank of England has come out with a paper dispelling fractional reserve. Commercial depository institutes create loans endogenously. The loan become the deposit. Loaning reserves is only bank to bank, and not to customers.

  4. So banks are guilty of electronic counterfeiting? If not wouldn't they be guilty of loaning at interest money that does not exist i.e. perpetrating a con job?

  5. I've been listening to a guy called Steve Keen and he makes the following criticism of the money multiplier (in my own words) and I hope Mr. Tabarrok or Mr. Cowen can explain where he's wrong.
    If a person wants a loan of $X, what's to stop the bank from just marking up their account by $X and looking for reserves later? After all, this does not change the equity of the bank so no foul play. To see how this works, imagine someone were to come to me and ask for a loan for $100. I could just write them an IOU for $100, and they could use that IOU to buy what they need. Reserves are only useful as a guarantee on the value of the IOU—if someone wants to come in and cash in the IOU, I need some cash in reserve. But once a reputation has been established for redeeming IOUs for real cash, people treat the IOU like it's real money and there's little need to cash in the IOU. (For a bank the IOU is the money that appears in your current/chequeing account. And a bank run is what happens when people lose confidence in the redeemability of the IOUs.)
    In principle, if people did all transactions in terms of the IOUs and nobody ever wanted to redeem the IOUs, the bank could operate without any reserves at all*. And the bank is free to print as many IOUs as it wants, constrained only by profit maximisation. In this way, banks do not need to look for reserves when someone asks for a loan. So the recursive series of transactions, each subject to a fixed "reserve ratio," doesn't seem to occur. You could always argue it's "as if" these transactions occur, and define the reserve ratio as Base money/Total money, but that turns the money multiplier into a tautology without any empirical content.
    When you view banking this way, it's totally predictable that the massive increase in reserves by the Fed didn't lead to hyperinflation. After all, reserves only exist to convince the public of the redeemability of the banks IOUs, to facilitate the occasional withdrawal, and to facilitate transactions between accounts belonging to different banks (see below). Once these functions have been fulfilled, more reserves doesn't lead to more loans.

    *This is not quite true since if a person with a Bank A IOU deposits it in Bank B, Bank B will want to redeem this IOU and there will be a transfer of reserves from Bank A to Bank B. Reserves are needed for this situation.

  6. Bank no longer create money in this manner. This is outdated information. What banks do is to have the customers seeking loans sign promissory notes. The bank take these promissory notes and deposit them in a transaction account. The bank then converts this promissory note into endogenous money which is then used to create a check, or exchange for cash. THE MONEY DID NOT COME FROM ANY EXISTING DEPOSIT. It was created based on a signature. Once the promissory note is paid off the promissory note is void, and the money supply shrink accordingly.

    The proof of what i am saying is in the empirical data in 2007. Bank reserves were in the tens of billions and consequently if you follow this model it should be in the hundred billion (about 200 billion if you follow this video). But instead we have credit upwards of 7 trillion. BANKS DO NOT LEND FROM DEPOSITS, THEY CREATE THEIR OWN MONEY BASED ON A DEBTORS SIGNATURE.

  7. There is no such thing as the "money multiplier", it's a moronic fiction that has been debunked countless times. When you deposit cash money into a bank, it does indeed stay in the bank as reserves, and only leaves the bank as withdrawals. Banks do not loan out their reserves, they do not loan money, period. Banks generate credit as deposits and call that a 'loan'.

  8. Oh No!. Not the money multiplier myth again.

    If you really want to understand how modern banks work and prepared to make the effort then I suggest the following :-

    The Bank of England – They should know as they run the show in the UK. As part of their Quarterly Bulletin for Q1 2014 they published :-

    "Money creation in the modern economy" ref

    The Federal Bank of Chicago – Published back in the 60's and unfortunately no longer available from their web site entitled :

    "Modern Money Mechanics" A Workbook on Bank Reserves and Deposit Expansion available from http://www.rayservers.com/images/ModernMoneyMechanics.pdf

    The UK based campaign group positive money have a good series of video's explaining things although not always perfectly.


    Also worth a read from the BOE :-


    and from CNBC an article Entitled "Basics of Banking: Loans Create a Lot More Then Deposits"


    Happy reading and eventually you may see the light, its not complicated at all when you realise how it works in real world terms and it all makes Logical sense.

  9. As if a bank would hold more than the minimum…especially in the current environment. In fact, I bet most banks consider the minimum reserve requirement as a target.

  10. This one is a fantastic explanation, strange that had to wait so long for a credible and meaningful video on a relatively common topic.

  11. this guy is very good at explaining something 95 % of world population doesn't have a clue about ….after watching the video they still can't get it …..

  12. The full formula for the money multiplier is 1/(reserve ratio) x 100 otherwise 1/10 would be 0.1 and that is NOT the multiplier as stated in your video – would be great if you made this clear other people might find it confusing

  13. Wow, this is extremely asinine. Banks don't lend out deposits, banks create loans and then wait for deposits.

  14. I don't get it. What is the purpose to get credit money and keep it in the checking account? When I need money I usually spend them.

  15. Very surprised at the number of clued-in people in the comments regarding endogenous money…. I wish academic economists were as quick to react to it, I have seen scant evidence of them even entertaining the idea in what little time I've spent studying the issue.

    Is it because it would shatter most of the models CBs use, or is it maybe that it would immediately call into question their legitimacy? They obviously know how all of this works, I just don't understand why they won't even begin the process of analysing it.

  16. Banks don`t lend anything. They create money out of thin air. Crisis happens because banks overlend and bigger % of personal income is dedicated to paying credit. Also because theres not too much investment in real industry and instead banks use credit to collect rents from the economy.

  17. Thank you so much Professor for crystal clear explanation. This concept is fixed inside my head and never to forget 🙂

  18. So the more that’s deposited, the value of the currency decrease because supply increased?

    Other words when interest rates are higher, the supply of money is high because businesses tend to hold off loans due to the cost of burrowing, but if consumers demand loans then that’s a set up for a economic downturn in the future.

  19. Sorry, but there's something i dont quite understand. In the example, new money is created when somebody makes a loan and puts the money in their account. But what is the point of taking out a loan only to put the money in the bank? Don't people who take out loans usually have something to spend the money on? Or is there something im missing? Thanks

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