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Main content
Current time:0:00Total duration:8:09
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POL‑2 (EU)
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POL‑2.A.4 (EK)
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POL‑2.A.8 (EK)

Video transcript

let's say for some reason you had lent the government 1000 dollars and so the government has given you a formerly issued piece of paper that says hey we the government owe you $1,000 this is issued by the Treasury this could be a Treasury bond it could be a tea bill of some kind and let's say that the Federal Reserve the central bank is interested in inserting money into our system so let's say this is the Federal Reserve right over here Federal Reserve and so what they do is they create $1,000 of Federal Reserve notes what we associate as paper money and they pay it to you and they buy that Treasury so that Treasury goes to the Federal Reserve from you and so and in exchange you get this newly created money and that the Federal Reserve just created so there you go you have this is $1,000 now what would you like Lea do with that $1,000 well it might not be safe to walk around town with your pockets bulging like that so a lot of folks would deposit it into a bank so let's think about what would happen to the bank's balance sheet so you go to Bank Bank a and I'm just gonna think about I'm gonna think about what was the balance sheet the pre-existing balance sheet for the bank but let's just think about what happens to its assets and its liabilities when you make that deposit a for assets L for liabilities if you deposit those thousand dollars then your assets for the bank is going to get $1000 in reserves in reserves but you didn't just give them the money they have a liability to you you should have a checkable deposited count now so we could say checking account so now you have a $1000 checking account which you would view as an asset for yourself but it's a liability for the bank at any time you could come and ask for that thousand dollars $1,000 checking checking account account and this would be for you now we've already spent several videos talking about fractional reserve lending and there's two ways we can conceptualize it as we've seen in those videos but I'm gonna go with the simpler version of fractional reserve lending and so this Bank says look we are in a world where our reserve requirement I will do a reserve requirement this actually is a typical reserve requirement the reserve requirement in this country is 10% which says that the bank only has to keep 10% of these cash reserves and then it can loan out the rest and so it does that that's its business model or a significant part of its business model and so what it does is instead of having 1,000 dollars in reserves it keeps 10% so it keeps $100 and it loans out the rest and so it loans out $900 so it's loaning out now $900 to someone else hopefully someone who is good for the money who maybe are gonna invest it into their business or they're going to buy a house or whatever else now once again the bank just didn't give them the money in exchange they get an asset which is an IOU from that person that person owes the bank money they owe them $900 so we could say that in exchange for giving them that cash they're going to have a $900 $900 loan on their balance sheet as an asset now once again the person that they lent the money to the loan would be a liability they owe the money but for the bank that's an asset hey someone owes me the bank $900 but then what's this person going to do well once again their pockets are going to bulge quite as much but they still might not want to walk around town with $900 in their pockets so they are likely to deposit in a bank and they could deposit it in bank a or they could deposit it in another Bank let's call it very creatively Bank B all right so Bank B same exercise I think you might see where this is going so it's assets its liabilities and so they go and they deposit these this $900 so you have $900 right over there and the corresponding liability you that person didn't give the money to the bank the bank owes can that person can demand that money at any point from the back and so you have a $900 $900 checking account checking account and that person would draw up on that checking account to buy the machinery for their business or whatever else but once again we have a 10% reserve requirement which says that the bank only has to keep 10% of that and so their bhisma business model is they do only keep 10% of it and then the rest of it they loan out so they loan out 810 dollars it could be a loan or it could be multiple loans altogether and I think you see where this is going and so this is lent out to someone else so now we have 810 dollars which can then be deposited in another bank bank see they can lend out 90% of that and that process keeps going on and on and on and on so an interesting question is given this infusion of $1,000 and given this reserve requirement how much total money has been created well in other videos we talked about the multiple measures of the money supply when the Federal Reserve put this 1,000 dollars a Federal Reserve notes into circulation they increased the monetary base by $1,000 but one measure of the monetary supply is well what are the Federal Reserve notes the coins the the federal and and the paper money that's in circulation plus the amount of chuckled about checkable deposits and we talked about that in other videos as m1 and so our m1 over here what's it gonna be well this person has a thousand dollar checking account $1000 checking account they think they have $1,000 that they can write checks against and they do and this person has a $900 checking account a $900 checking account and then this person right over here then when they deposit their money they're gonna think they have an 810 dollar checking account they have that and then that process is gonna go on and on and on and on someone else when this $810 gets deposited the banks gonna lend out 90% of that that person is gonna think they have that amount of money and so what we do is we're just multiplying by 0.9 every time we're multiplying by one minus the reserve requirement every time and we've done the mathematics on this multiple times this is going to be equal to one thousand dollars the initial amount that was put into the monetary base times 1 over 1 minus 0.9 and that is just going to be equal to $1,000 times 1 over 0.1 or you could just view this as 1 over the reserve requirement it just happened to be 0.1 in this example a reserve requirement and you could do the math on what that's going to be 1 divided by 1/10 is going to be 10 and so our m1 money supply that has been created in this very simple example is going to be equal to it's going to be equal to 10 times $1,000 so it's going to be equal to $10,000 so big picture when the monetary base is increased by a certain amount if you know the reserve requirement and if you assume that all the banks minimize their reserves that keep only the 10% they don't keep 11% or 12% or 20% then what this calculation is going to show you is what is going to be the maximum effect on m1 given that infusion into the monetary base and all it is is the amount that was infused times 1 over the reserve requirement