[MUSIC] Now that we know more about money, let's find out how money is created. The best way to think about this is to go back several hundred years to England when commodity money such as gold was the prevailing medium of exchange and goldsmiths emerged as the first commercial bankers. In this earlier era, people didn't like to carry around all their gold or leave it sitting around the house because it was cumbersome and might even get stolen. So people asked their goldsmiths to store it. The Goldsmiths' intern would give the gold depositors a paper receipt. And when a depositor needed to get some gold to make a purchase, he or she would use that receipt to redeem the gold. Now, over time, three important things happened with this system. First, the depositors figured out that they could trade their gold receipts for goods rather than go back to the goldsmith to redeem the paper every time they needed to make a transaction. These receipts functioned in effect as the first paper money. Second, the gold depositors soon figured out that they didn't have to leave their gold with the goldsmith for free. In fact, it wasn't long before goldsmiths began competing for depositors' gold. In those good old days, they didn't offer free toasters and rebates to open an account, they did offer them interest on their gold deposits. Finally the goldsmiths figured out, that they could operate under what is today called, a system of fractional reserves. For example, they might take in a $1,000 of gold deposits and issue receipts for that amount to the depositors. However, they then might turn around and also issue another $1,000 in gold receipts as loans to other people, even though they didn't have enough gold deposits to redeem all the receipts that they issued. The goldsmiths could operate this way because it was highly unlikely that everybody who held the $2,000 of receipts would all come in at once to demand their gold. In this particular example, the implicit fractional reserve is 50%, or 0.5. At this level, the goldsmiths would issue twice as many receipts as they had gold deposits for. And such a system allowed the goldsmiths to expand the supply of money over and above the amount of gold reserves they held in their vaults. Today's modern banks function much like the gold smiths of old. And you can see now how such banks can create money. Suppose, for example, a person deposits $1000 in Bank 1. This table shows the balance sheet for bank one, in this initial position, where both reserves and deposits are $1000. Now suppose further that the banks board of directors decides that they are going to maintain a fractional reserve, or reserve requirement, of 10%. This means that the board of directors is betting that no more than 10% of their depositors will come in and demand their money at any one time. This in turn means they can safely lend out at least $900 of the new $1,000 demand deposit. This table shows bank ones balance sheet after making such a loan. Deposits remain at $1,000, but reserves fall to $100, while loans and investments go to $900. At this point, the borrower from bank one deposits the money in bank two. And this is reflected in bank two's initial balance sheet in this table. But since Bank 2 also has a 10% reserve requirement, it can lend out funds, $810 to be precise, as indicated by Bank 2's final balance sheet in this table. By now you get the picture. When $810 is deposited in Bank 3, Bank 3 lends out $729. Bank 4 lends out $656, and so on. And from this table, you can see how the actions of all the banks together produce what is called the multiple expansion of money. The final equilibrium is reached when every new dollar of original bank reserves supports $10 of demand deposits. And through this expansion, the original $1,000 demand deposit creates an additional $9,000 of new loans and investments, and a total of $10,000 in new deposits. From this example, we see that there is a new kind of multiplier operating on bank reserves. A money supply multiplier very different from the Keynesian expenditure multiplier. Perhaps your obvious question is, how do you calculate this multiplier? It's a good question and fortunately there's a very simple formula for it. The money supply multiplier is simply one divided by the banks required reserve ratio. So in the example above if the reserve is 0.10 or 10% then the money multiplier is ten. And ten times the original $1,000 increase in demand deposits is $10,000. Now you try it. Suppose the reserve requirement is instead 50%. What's the money multiplier? That's right, it's two. 1 divided by .50. So, if bank one receives a new demand deposit of $1,000, it can lend out $500. Bank two can lend out $250 and so on, until a total of $2,000 of new money is in circulation. Now the bigger the reserve requirement, the smaller the money multiplier and the less money that is created by a new dollar of demand deposits. Now if you had been listening closely, there is probably something bothering you. You might want to know where in the example above the $1000 of paper money that was deposited in Bank 1 originally came from. In America the answer is The Federal Reserve, the nation's central bank. Here its control of bank reserves. The Federal Reserve sets the level of interest rates and has a major impact on output and employment. The Fed, as it is called, was created in 1913, following the financial panic of 1907. During this panic, numerous banks collapsed because of so-called runs on the banks. A bank run occurs when too many of the bank's depositors demand their money at the same time. To see the serious problem a bank run creates, imagine what would've had to our goldsmith in the example above if everybody had showed up all at once, demanding their $2,000 in gold. And the goldsmith had had only $1,000 of gold in his vault. Such bank runs usually happen because, for one reason or another, people suddenly believe that they may not be able to get all their money out of their bank. The irony, of course, is that when everybody tries to do that at once, their fear becomes reality. In effect, a self-fulfilling prophecy. And that's where a central bank comes in. It can serve as the lender of last resort. So that if a bank needs money to pay off its depositors, it can always borrow it from the Fed, which is in essence, a banker's bank.
