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The Money Multiplier
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The Money Multiplier

How Do Banks Affect the Money Supply?

Understanding Fractional Reserve Banking

  • The concept of fractional reserve banking is introduced, explaining how banks do not keep all deposited money in reserves but lend most of it out.
  • Large banks in the U.S. are required to maintain a reserve ratio of at least 10%, meaning they must keep $1 for every $10 deposited.
  • The reserve ratio can fluctuate; banks may hold more than the minimum if they anticipate high withdrawal demands or low loan profitability.

The Money Creation Process

  • When a bank lends out 90% of a deposit, it creates new deposits, thus increasing the overall money supply (e.g., from an initial $1,000 deposit).
  • This lending process continues as each subsequent borrower also deposits their loans back into the bank, further amplifying total deposits.

Calculating the Money Multiplier

  • The "money multiplier" is defined as 1 divided by the reserve ratio; with a 10% reserve ratio, this results in a multiplier of 10.
  • A key distinction is made between cash given directly (which creates new reserves) versus checks (which merely transfer existing funds without creating new reserves).

Role of the Federal Reserve

  • The Federal Reserve has significant control over money supply through its ability to create new money and inject it into the banking system indirectly.
  • While banks typically hold at least 10% in reserves, actual multipliers often hover around 3 due to varying bank behaviors regarding reserves.

Impact During Economic Fluctuations

  • Factors such as reluctance to lend during recessions and increased cash holding by individuals can lower the money multiplier effect.
Playlists: Economics [Intermediate] Pt.1 Principles of Economics: Macroeconomics Unit 10: Monetary Policy and the Federal Reserve
Video description

When you deposit money into a bank, do you know what happens to it? It doesn’t simply sit there. Banks are actually allowed to loan out up to 90% of their deposits. For every $10 that you deposit, only $1 is required to stay put. This practice is known as fractional reserve banking. Now, it’s fairly rare for a bank to only have 10% in reserves, and the number fluctuates. Since checkable deposits are part of the U.S. money supplies, fractional reserve banking, as you might have guessed, can have a big impact on these supplies. This is where the money multiplier comes into play. The money multiplier itself is straightforward: it equals 1 divided by the reserve ratio. If reserves are at 10%, the minimum amount required by the Fed, then the money multiplier is 10. So if a bank has $1 million in checkable deposits, it has $10 million to work with for stuff like loans and reserves. Now, typically, the money multiplier is more like 3, because banks can always hold more in reserves than the minimum 10%. When the money multiplier is higher, like during a boom, this gives the Fed more leverage to move M1 and M2 with a small change in reserves. But when the multiplier is lower, such as during a recession, the Fed has less leverage and must push harder to wield its indirect influence over M1 and M2. Next up, we’ll take a closer look at how the Fed controls the money supply and how that has changed since the Great Recession. Subscribe for new videos: http://bit.ly/1Rib5V8 Macroeconomics Course: http://bit.ly/2eHWWtC Next video: http://bit.ly/2udpA7U 00:00 Fractional Reserve Banking 01:07 Reserve Ratios 01:52 Impacts on the Money Supply 03:18 The Money Multiplier 03:58 The Federal Reserve 05:37 Recessions