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Macroeconomics
Course: Macroeconomics > Unit 4
Lesson 4: Banking and the expansion of the money supply- Overview of fractional reserve banking
- Money creation in a fractional reserve system
- Weaknesses of fractional reserve lending
- Full reserve banking
- Simple fractional reserve accounting (part 1)
- Simple fractional reserve accounting (part 2)
- Lesson summary: banking and the expansion of the money supply
- Introduction to fractional reserve banking
- The money multiplier and the expansion of the money supply
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Overview of fractional reserve banking
Central banks create money by printing it or making electronic money. They put money into circulation by buying securities, like government debt. Banks use fractional reserve lending, keeping a portion of deposits and lending the rest. This process multiplies the money in the economy. Checks help money move without being withdrawn. Created by Sal Khan.
Want to join the conversation?
- -Why when the banks are giving loans to the following banks does their money 'in-house' not become reduced to 1$? I don't understand why 3$ could physically turn into 6$ if no more dollars were printed. (conservation of mass?) 4:50(17 votes)
- If Bank A lends to Bank B, Bank A gets to claim that owed money as an asset on it's books as does Bank B because it actually has the money or its electronic equivalent. So, for example, if you have 100 dollars, and you loan your buddy 50 dollars, you can say you have 100 dollars in assets ( the 50 you have and the 50 you are owed) and your buddy can say he has 50 dollars in assets. The total is now 150 dollars. Then your buddy lends 25 dollars to his mom. He can claim 50 dollars in assets ( 25 in hand and 25 owed) and his mom can claim she has 25 dollars. The total is now your 100, your buddy's 50, and his mom's 25 for a total of 175 dollars that everybody says they "have" from the original 100. Of course it is really 100, but the key is that everybody is now acting(spending) like they have money and this drives the economy. If your buddy and his mom would have waited until they actually had un-borrowed money to spend, the thought is that the economy would suffer from inactivity.(81 votes)
- @Sal said 'they go out into the open market and buy securities' what exactly are 'securities'? He has mentioned them several times in other videos, and I still don't know what they are. 2:05(20 votes)
- when someone or a company buys bonds, they are essentially lending out money. the bonds are certificates that guarantee repayment of your money that you invested to buy the bond, along with a pre-determined interest. securities are any tradable assets, such as stocks, banknotes, etc. Bonds are one type of security.(20 votes)
- Fractional reserve banking increases the money supply by lending out the money multiple times over -- so doesn't this by nature result in debt (that cannot be paid back) and/or inflation.(7 votes)
- The principle and interest can be paid back because the interest paid to depositors, operating costs of the bank, and profits all have a path back into the economy. Fractional reserve banking facilitates an increase in the velocity of money; as such it does impact inflation. The bank's cash reserve limit and the limits of banking technology prevent the velocity of money from increasing indefinitely. The choices of all agents in the economy to spend, save, or borrow determine the actual velocity of money.(2 votes)
- @2.05 I want to see if I understand this. The government will buy securities and the newly created money used to buy these securities then enters the economy as "new money". So when the government collects on the security at its maturation that money will be government revenue? Is there a reason that the government cannot just add the newly created money into its programs as additional revenue?(3 votes)
- You are confusing the government with the central bank. The government sells securities in order to raise money for its programs. The central bank then buys those securities and the money used will enter the economy. At maturation, the government pays the owner of the security (the central bank) back the principal and some interest. That money will go out of the economy, but fortunately (maybe?) the central bank can buy newer government securities. This will continue to work as long as the government is in debt.(3 votes)
- Are the banks required to keep only a certain amount on reserve and lend out the rest, or can they hold on to all of it if they want?(2 votes)
- They don't have to lend, but they want to, otherwise they are paying interest to depositors and they are not earning any interest on the money they have not lent out. So, typically what they will do with money they have not lent to individuals is to lend it to the US government by buying treasury bonds.(5 votes)
- So if everyone were to go any try to withdraw all of their money at once, would our entire economy collapse entirely?(2 votes)
- Yes, pretty much. That's called a bank run, and that's why we have deposit insurance and it's also why the Fed can lend money to banks that are short on reserves, as a last resort.
With deposit insurance, there is no reason for everyone to try to withdraw money all at once, since they are guaranteed to be able to get their money at any time. And if too many withdrawals do occur, the Fed can step in and make unlimited loans to banks so that they can cover the withdrawals. Bank runs were common before we had deposit insurance and the Fed. Now they are unheard of (in the US).(3 votes)
- How does the Dodd-Frank Act affect this model?(3 votes)
- I would type in Dodd-Frank Act to find out more about it.(1 vote)
- Now we know the true reason of ATM withdrawl limits per day.(3 votes)
- The check writing example seemed to say that the apple buyer's $1 never leaves the bank. But when the apple seller, who now owns that $1, cashes the check the $1 will leave the bank. I don't understand how the checking system creates money, doesn't it just reassign ownership of the $1?(2 votes)
- The $1 doesn't leave the bank with the written check. When the apple seller goes to cash the check, the bank doesn't normally just give the seller the $1. The bank most often transfers the $1 from the buyer's checking account to the seller's account, but keeps the $1, most of which it may have given out as a loan.(1 vote)
- At, what would happen if the person wanted to pay for the apple with dollar bills or coins, instead of a check? 7:01(2 votes)
- One would be paid in cash by the bank from its reserve providing there is enough money to pay out. If there isn't and the bank is unable to find the cash elsewhere it would be breaching its own T&Cs. At this point it may be declared bankrupt. The person would get one's money back, usually up to around 100k Euros in the EU, providing the bank was backed by a deposit guarantee scheme.(1 vote)
Video transcript
What I want to do
in this video is give an overview of how money
is created in most market based economies, and even a little
bit of a discussion of what really is money. And we can go into much
more depth in future videos. And I think in many
videos I already have gone into a much
more technical depth. In most market based
economies right now there is a central bank, which
is essentially the actor, they do many things. They often will be a
regulatory agency as well. But their main role is to
have the right to print money, and to put that money
into circulation. And I'll rely heavily
on the model of the US. That's hard to read. The central bank
in some countries is formerly part
of the government. In other countries,
it's pseudo-independent. In the US. It's more of the
pseudo-independent flavor of a central bank, although
obviously closely connected with the government. The US Federal Reserve,
a lot of the leaders are appointed by the government. It's excess profits go
back to the government. And so obviously it has very
close ties to the government. But when the central bank
decides to print money, it literally can just create it. It could literally
print physical money. Or it can create
electronic money, which has the same exact effect. So let's say the central
bank, it goes out there and it goes out there
and it prints three-- and we'll just focus on
the physical right now. It's a little bit
easier to conceptualize. And it just goes out there and
it prints three physical dollar bills. Now it has to figure
out, how does it get it into circulation? How does it get it
into the economy? And it does not just
put it into a helicopter and drop it from
that helicopter. Sometimes, in certain
circumstances, it can lend to this directly to
banks, certain types of banks, member banks. But the typical way that
this enters circulation is that the central bank will
use this newly created money, this newly created
reserves I should say, to go out into the open
market and buy securities. And they typically buy very
safe securities, typically government debt. So they will go
out there and they will put this into circulation. And in exchange they
are buying securities from the open market. So then these securities
from the open market will go to the central bank. So these are securities, or
maybe we could call them bonds. And once they do that, then
whoever had these before, whoever was the owner of
the securities before, they just sold them. Now they have
these dollar bills. And they could either directly
spend those dollar bills or they could deposit those
dollar bills in a bank. If they spend the
dollar bills, then whoever they gave those
dollar bills to at some point would want to
deposit it in a bank. Some way, by buying
these securities, someone now has
these dollar bills. And they will deposit
them in a private bank. So let's draw that. So right over here
is a private bank. And now it has the dollar bills. It has these reserves now. It has the reserves. Now, that's not the
end of the story. This money can now be lent. And this is key,
because this is what's typical in most
market economies where they have fractional
reserve lending. So fractional reserve lending,
which is a bit strange, because you are telling the
person who just deposited this money right here, that
you can go at any time and you can take this money out. We've got this money for you. You can trust us. You don't have to be
paranoid about what's going on with this money. But the reality
is that this bank is allowed to keep only a
fraction of these reserves, and lend to the rest of it out. In order for this system
to not be super fragile, the Central Bank then
also insures these banks. But we'll talk about
that into more depth. But here. I just want to show you
how the money is created in this fractional
reserve lending system. So this bank right
over here says, well I have to keep a
little bit of these reserves in case that guy comes. The probability of
all my customers coming on the same day and
asking for all of their money is low. I just have to keep a little
bit for whoever does come. And then the rest of
it I can lend out, even though I promised everyone
that all of their money is available. And so they lend
it out to whoever needs to borrow that money,
who looks like a decent risk. And those people might
not spend it immediately. And so they would
deposit it into a bank. Or they might spend
that money immediately. They by a factor,
or they buy a car. They do something with it. And whoever they bought
that new thing from, those people now have
the money and they will deposit it into a bank. And so this newly
lent money will then end up in perhaps another bank. It could even be the same bank. So that will also end up
in a bank, right over here. And now this bank,
it can also only keep a fraction of the reserves
and lend out the rest. And for simplicity, in
most banking systems, they only have to keep
on the order of about 10% of the reserves in house, and
the rest they could lend out. But over here. I'm keeping much
larger reserves just for the sake of making it
easy to draw this diagram. So this bank right
over here, maybe it decides to keep
this dollar bill, and it could lend this
one right over here out. And once again, when it
lands that dollar bill, it will end up
somehow-- the person they lend it to might keep
it in a bank temporarily. Or they might immediately
buy something. And when they buy something,
it will eventually end up in a bank because the
person they bought something from will deposit that money. And so it could end
up in another bank. And now this is interesting,
and in future videos we'll go into more of the math
of exactly how much money is being created. And it's an interesting
mathematical problem. Actually, it's a sum of an
infinite series, and all that. And you can look
that up if you're interested in those ideas. But the basic idea here is even
though the central bank printed three units of base money,
$3.00 right over here, there's a lot more
money in the system. You have this guy, who made this
deposit, thinks he has $3.00. This person thinks
they have $2.00. This person thinks
they have one. So just in this example over
here, we have one, two, three, four, five $6.00. So just right over here we
have $6.00 in this system. And you might say, well,
is this really money? This is deposited. This guy thinks he has
it, but he's not using it. If he had to use it he
would have to withdraw it, and then the bank wouldn't
be able to do this. And this is where checking
accounts are really important. I'm assuming that these were
on demand checking accounts. So this guy, the
reason why he's not going to withdraw this
money, is he can still use it as money
by writing checks. So if this guy, let's say this
is all the money that he has, and he decides if he really
needs to buy an apple. And that Apple costs $1.00. So this is my drawing of
an apple right over here. He does not have to withdraw
this $1.00 out of the bank. He can write a check. So right now he has claims to
all three of these dollars. He can write a check to
the apple vendor, so $1.00. He writes a check, gives
it to the apple vendor, and now he'll get the apple, so
this check is acting as money. And now the apple vendor
will have the rights to one of these dollars
right over here. And now the apple vendor
could write a check. So this dollar never has to
leave the banking system. But because of checks
it is essentially enabling-- this check writing--
is enabling these transactions to occur. So it's still
enabling, either you could view it as it's still
acting in some forms of money because the rights
to it can change, even though it's sitting out
in here and it's been lent. Or you could say that it's
enabling the writing of checks that are acting as
some form of money. And the whole reason
I want to do this, I'm going through
this exercise, is to show you that the amount
of money in circulation isn't really in
the Central Banks, or not directly in the
Central Bank's control. They can definitely decide,
hey I'm going to print money, buy securities, put
it into circulation. Or if they want to take
money out of circulation, they can decide to
sell these securities. And then when they
sell the securities, maybe this guy will
buy them, those dollars will go back to
the Central Bank. And maybe they could put
it out of commission. But you have this whole
effect right over here. If you have more
lending occurring, if the banks are feeling very
confident, then more of this will happen. You will get more of this--
the multiplier effect of this lending. And if less lending
is happening, then you could potentially
see all of this contract.