Money! The Money Multiplier http://blog.spendingdoctor.com/wp-content/uploads/2011/12/piles-of-money1.png

How banks create money Fractional Reserves You deposit some currency 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 Step 2: People deposit cash in bank. Step 3: Bank sets aside reserves + loans out the rest $900 $100 $1,900 Step 4: People spend their loans on stuff/ Merchants deposit their earnings into the bank. Step 5: Same as #3 $810 $190 $2,710

That’s how banks create money. Now… how much do they create? http://www.illustrationsource.com/stock/image/37887/businesswoman-and-money-bag-on-see-saw/?&results_per_page=1&detail=TRUE&page=19

The Money Multiplier Basic 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 http://www.costrecoveryagents.com/images/Leaky%20bucket_resized.jpg

The money supply depends on Currency 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 now Monetary Base Fed can control: Currency in circulation, plus Reserves held by banks Money Supply Created by the market: 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.