Money!The Money Multiplier

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How banks create moneyFractional Reserves

◦Banks do not hang on to all of your deposits They need to use them to make a profit

You deposit some currency◦Bank holds on to some of it: “Reserves”

Bank loans the rest out.Those loans turn into currency

◦People buy stuff with borrowed money. The borrowed money goes into circulation…

How banks create money:Currency in Circulation

Reserves Demand Deposits

MONEY SUPPLY

Step 1: People have cash

$1,000 $0 $0 $1,000

Step 2: People deposit cash in bank.

$0 $0 $1,000 $1,000

Step 3: Bank sets aside reserves + loans out the rest

$900 $100 $1,000 $1,900

Step 4: People spend their loans on stuff/ Merchants deposit their earnings into the bank.

$0 $100 $1,900 $1,900

Step 5: Same as #3 $810 $190 $1,900 $2,710

That’s how banks create money.Now… how much do they create?

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The Money MultiplierBasic Theory:

◦Given a Reserve Ratio of 10% $500 turns into….

$5,000 Assuming a perfect, bank-deposit-only world.

Checkable deposits ÷ Reserve ratio.◦What would a reserve ratio of 20%

do? $500 turns into

$2,500… The bank has to hold on to more.

Real life isn’t quite that simple.

Where could money leak out of this system?◦People carry money in

their wallets◦Not 100% of every loan

goes to a merchant Sales tax Money leaves the GDP…

◦Banks can hold excess reserves

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The money supply depends onCurrency

◦How much people choose to hold vs. spend How much currency is in circulation

Bank deposits◦How much banks hold excess reserves

The Federal Reserve sets required reserve ratios Link:

http://www.federalreserve.gov/monetarypolicy/reservereq.htm - table1

Anything more the bank wants to hold = excess

Normal times, they don’t want these…

Subtle difference that’s important nowMonetary Base

◦Fed can control: Currency in circulation, plus Reserves held by banks

Money Supply◦Created by the market:

Currency in circulation, plus Checkable Bank Deposits (aka Demand

Deposits)

Monetary Base vs. Money Supply

What’s the real money multiplier?Ratio of the money supply to the

monetary base.In the U.S., it used to be ~1.9

◦So, every dollar of bank reserves supports $1.90 of money supply.