Required Reserves and the Deposit Multiplier - Video Tutorials & Practice Problems
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Bank Balance Sheet and Money Supply
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Alright, so let's see how checking account deposits can have a multiple effect on the money supply, meaning that the amount of money being saved in a bank rather than saved under your mattress can actually increase the money supply by a multiple amount. So, remember when we defined M1, we included the currency in circulation and checking account deposits, right? That was the significant portion of M1 was the currency in circulation. And the amount in checking deposits. So that's how we define the money supply. So now we're gonna think about from the bank's perspective, we're gonna be looking from a bank perspective and see how the money supply is affected. So reserves are deposits that the banks have received but not loaned out. Okay, So what we're gonna see is that banks, when they hold deposits, they're not going to have all of that money just sitting in the bank. If you go to the bank and you deposit $1000 well, they're going to take that $1000 and they're gonna loan some of it out and they're gonna keep some of it as reserves just in case you go and make a withdrawal and the rest of it, they're gonna loan out. So the idea here is that they're not expecting you when you put the money in the bank to just withdraw all your money at once. And if you did, well, they have other people's reserves to help maintain that now. Um So in general, what they're gonna have is a certain portion of each checking account deposit on reserve and that's what's called the reserve ratio. The amount of deposits that the banks have to keep in cash. And this is usually mandated by the government what that reserve ratio is. So generally they're only gonna keep a fraction of their deposits as cash. And let's go ahead and go through this this example and see how the money supply is affected by this reserve ratio. So let's start here where clutch Topia originally has no banks. And the total amount of currency in circulation is equal to $1000. So what is the money supply in this case the money supply is gonna be the currency in circulation? The $1000 plus zero in banks, right? The deposits are zero. So I'll say currency in circulation CC for 1000 and zero in deposits. So there's 1000 there in our money supply. Now let's go on where first bank of clutch opens and clutch tokens are so excited that they deposit all $1000 in the bank. They deposit all $1000 in the bank. So we're gonna go through a banks kind of balance here. So over here we're gonna have the assets of the bank, what they own and the liabilities of the bank over here, what they what they owe, Right? So we're gonna say um how much money they have in liabilities and how much they own. So generally what we're gonna see Is that the liabilities when people deposit the money into the bank. Well, they're gonna have deposits, right, these are liabilities that they have, that they go to to the people who deposited, they're gonna have $1,000 as deposits that they owe to their people. And they're gonna have assets, they're gonna have cash Of $1,000, right? So they have this $1000 in cash, but they owe it to somebody. It all belongs to someone else as a liability there. So, what is the money supply in this case? Right now? How much currency in circulation is there? There's none. Right? Everyone deposited their money in the bank and the bank is holding all 1000 as checkable deposits. So the currency in circulation is zero, and the deposits are now 1000. Cool. So let's go through a few definitions of Of related to these these reserves and how we're gonna start seeing the money supply multiply based on these deposits. So, the first system that we've seen so far is 100% reserve banking system, a system where all deposits are held as reserves. So in this case, the reserve ratio would be equal to one, right? one. When we, when we define the reserve ratio, we're talking about reserves over deposits. So, if everything is held, if everything is held as reserves, all $1000 that were deposited in the bank are being held as reserves. Well 1000 divided by 1000 gives us a reserve ratio of one, all 100% of deposits are held. But now we're going to get into a system of fractional reserve banking, a system where the bank holds only a fraction of deposits as reserves. So the rest of it, they're going to loan out. And this is going to be a system where a reserve ratio is less than one. Okay, It's gonna be some some number less than one where the reserves are less than the deposits. Right? So we're gonna have $1000 of deposits and say $600 of reserves. Right? That would be a 60% reserve ratio. 600 divided by 1000 something like that. So required reserves. These are reserves that a bank is legally required to hold. And this is based on some mandated reserve ratio from the government. The government's going to say, Hey, you have to keep 10% of your reserve of your deposits as reserves, whatever that might be. So, excess reserves are reserves held over the legal requirement. So if you hold more, if the legal requirements, 10%, but you're holding 20% as reserves, that's excess reserves. Everything above the legal requirement. Alright, so let's go ahead and pause here. And then we're gonna see how this reserve ratio, uh less than one. When we have a fractional system, how it affects the money supply. Cool. Let's do
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Required Reserves and the Deposit Multiplier
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Alright, so, let's go ahead and wrap up our example here and see what happens with the money multiplier. So, the money multiplier is the amount of money the bank generate for each dollar of deposits. So, every time there's a deposit, Well, they can loan out a portion of it because of the excess reserves and they keep getting more and more out of it. All right. So, what did we see in our example? We saw an initial deposit of $1000. Right? And then second bank of clutch. Well, they first bank of clutch held 10% of it and the other 90% went to second bank of clutch. Right? We saw the $1000. So, let me write the 1000. Actually, I'm gonna write them over here. 1000 and then second bank of clutch got 90% of it because 10% was held as reserves at first bank of clutch. The other 90% went to second bank of clutch. And then they loaned out that excess reserves. So the 900 Time 0.9 went to 3rd Bank of Clutch 810 and so on. 810 times 0.9 gave us the 7 29. And this would keep going. The 7 29 times 10%. Right? And then that times 10%. That times 10%. And there's a mathematical equation that we can use that we're not gonna get into the mathematical details about because we don't need to. But what it tells us is that it comes out to a total change Of $10,000. So that 1st $1,000 deposit gets multiplied 10 times. So how does the reserve ratio get involved in that? Because think about if the reserve ratio had been higher and they had to hold say 20% as deposits. Well, they wouldn't have been able to make such a big loan. Right? The second bank wouldn't have received $900, they would have received $800. And there would've been less of a multiplier. So the more reserves you have to hold, the less the multiplier is gonna be right because more reserves means there's less available to be loaned out and be multiplied. So the lower the reserve goes, the more we can get out of these loans. So the money multiplier ends up being save us the mathematical uh mumbo jumbo comes out to be one divided by the reserve ratio, easy as that. So in this case we had one divided by our reserve ratio of 10% 100.10 and that came out to be 10. So our initial deposit of $1000 Got multiplied 10 times to a total increase of $10,000. So our money supply would be $10,000 in this case, from that initial $1000 deposit. That's pretty crazy. Right? We started with just $1000 and through this series of loans and deposits, it came out to be worth $10,000 of money supply available. Okay, so just to reiterate here, we've got a reserve ratio right next to it. Reserve ratio is defined as the amount of reserves you hold divided by the deposits. Generally when you see a question, they're going to tell you the reserve ratio straight up, they'll tell you the reserve ratio is 10% 5% 20% whatever it might be. Okay, So there we go, the money multiplier is going to take one checkable deposit and turn it into a significant increase in the money supply. Alright, let's go ahead and move on to the next uh