How Banks Create Money - Macro Topic 4.4 - Hey, hey you econ students. This is Mr. Clifford, welcome to AC-DC Econ. Right now we're here to talk about how banks create money out of thin air. Whoa! [MUSIC PLAYING] - You heard me right. Banks create money out of thin air. To explain how this possible, let's talk about what a bank does. A bank accepts deposits from its customers. But it doesn't just hold that money. If all banks did was hold other people's money, there would be no profit in that. Instead it what a bank does, it takes that money, and it loans most of it out. Now why can't it loan all of it out? Well, because sometimes customers come back and they want to withdraw some of that money. So if you and I and everybody else goes to the bank at the same time to get our money out, the bank does not have that money. They wouldn't be able to pay us, and the bank would default. Now that's called a bank run, and it's bad. Really bad. Now the United States we have deposit insurance make sure bank runs like that don't happen. But the point is, the bank doesn't hold all those deposits. They loan it out. Now the amount of deposits that the bank needs to hold by law is called a required reserve. In the United States, it's 10%. This means that the other 90% is something called excess reserves, and they're free to loan that out. It'll make a whole lot more sense with an example. Let's say someone goes into a bank and deposits $100 in their pocket into the bank. Now this won't change the money supply because, money from your pocket is part of the money supply. So is demand deposits inside banks. So, so far there's been no change in the money supply. But here's where the magic happens. The bank is going to hold a certain percentage, by law, let's say 10%. So they will hold $10. That means you a loan the other $90 out. Now the person who deposited $100 has $100 in the bank. But the person who borrowed that the $90 also has now $90. That $90 is money that was created from thin air, that does not exist until the loan occurred. Now that person is going to spend that $90, and eventually that $90 can make its way back into another bank. That other bank is going to take that $90. It's a whole 10% in required reserves. So $9 is going to hold, and it's going to loan the other $81 out. That $81 new dollars is new money supply. It was not created until the loan occurred. Now eventually the person who borrowed the money is going to take it, and spend it, and that's going make its way to a new bank. And the same thing is going to happen again and again. And again, and again, and again. Now it turns out that the initial deposit of $100 is actually going to become $900 of new money created. the way I got this is by looking at what we call the money multiplier, which is one over the reserve ratio. So in this case, when the reserve ratio is 10%, that meant the money multipliers is 1 over 0.1, so it's 10. Now you might be asking yourself, if the initial deposit was $100, and the multiplier is 10, why didn't $1,000 of new money get created? The reason why is because the initial $100 was actually part of the money supply to start off with. So the only amount of new money that was created was from the initial loan of $90. So $90 times 10 is $900 of new money created from the initial loan. And this is the whole idea of fractional reserve banking. Banks for a portion of deposits, and they loan the rest out. And whenever they loan it out, they create new money. Did you get that? Here, let me ask you a question to see if you actually fully understand that concept. Let's assume instead that the reserve requirement is 20%, and someone deposits $500 into their bank, from their pocket, in the bank, $500. Assuming that banks loan out all of their excess reserves, and there's no other leakages, how much would be the increase in the money supply? Well, the money multiplier is 1 over 0.2, and the multiplier is 5. That bank is going to hold a $100 in required reserves, and their excess reserves of $400 they're going to loan out. That $400 is all new money, and all the other steps cause new money. And so it's $400 times 5, which is $2000. No don't confuse this idea of skipping that first round with the same idea the Fed buying bonds. For example, if the Fed bought $500 worth of bonds, so the Fed buys bonds, it puts $500 in the system, that whole $500 is new money. So in that situation, the new money created will be 500 times 5, which would be $2,500. Now this is tricky, but it's just like the spending multiplier that you learn back when you learned fiscal policy. Make sure and take a look at my other videos, and my review app for the AP economics test. Until next time.