Okay, let's talk now about a money supply multiplier. It is very different from the Keynesian expenditure multiplier we developed in our last lesson. What we want to come to understand is the relationship between any given reserve requirement set, the banking system of fractional reserves, and the corresponding rate of money creation. In fact, there's a very simple formula describing this relationship. Money supply multiplier is simply one divided by the bank's required reserve ratio. Let me repeat that because this is a key formula that you will want to commit to memory. Money supply multiplier is simply one divided by the bank's required reserve ratio. So, what's the money supply multiplier if the reserve requirement is 10%, 25%, and 50%? And what happens to the money supply multiplier as the reserve requirement rises? Take a minute now to jot down your answers. Maybe also think about why your results should be very intuitive. Okay. If we simply apply our formula that gives us the money supply multiplier by dividing the number one by the reserve requirement, we see in this table that the multiplier falls from 10 for a reserve requirement of 10% to only two for a reserve requirement of 50%. And this should indeed be an intuitive result because the higher the reserve requirement for a bank, the less money it can lend out and therefore, the less money the lending process will create. Well, I can't tell you where babies come from. Maybe take a biology class for that, but I can shed a little bit more light on a question that may be bugging you. Particularly if you've been listening closely to our story about how private banks help create money, you may have wondered where the original $1,000 that was first deposited in the first bank in our example from the last module came from. The answer, whether it's dollars or euros or yen or yuan, what we are all talking about is the same. And this answer is that in most nations of the world, it is the government and government runs central banks that create and control the money supply. There is a very big reason for this. The reason why the government usually gets involved in the banking system of its nation is simply this, and it has to do with a key concept of a bank run. To understand the concept of a bank run, consider how the central bank of the United States, known as the Federal Reserve, was born. The Fed, as it is called, was created in 1913 following the financial panic of 1907. During this financial panic, numerous banks collapsed because of so-called runs on the bank. In this key definition, a bank run occurs when too many of the bank's depositors demand their money at the same time. See the serious problem a bank run creates, imagine what would happen to our goldsmith. In the previous module, if everybody had showed up all at once, demanding their $2,000 in gold and the goldsmith had only $1,000 of gold in his or her wallet. 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, the fear becomes reality. In effect, a self-fulfilling prophecy. That's where a nation's central bank comes in. It can serve as the so-called lender of last resort. Let me repeat that key term because it is well worth remembering, lender of last resort. In this case, if there is a run on the private banks in the nation, the government's central bank can come in and lend to the banks under pressure the funds they need to pay off their depositor. In effect, the government central bank thereby serves as the lender of last resort. Effectively, a banker's bank, it lends to the private banking system. So, here's a question for you. Is the probability of a bank run on the private banking system higher or lower if the nation has a central bank it serves as a lender of last resort? Take a minute to think about that now, and jot down an answer before moving on. In fact, the beauty of having a nation's central bank serve as the lender of last resort is that once depositors are confident that the government will back up their deposits, it will be far less likely to attempt to run on that private bank. In this way, a nation's central bank can lend stability to the private banking system, but that's hardly the only function of the central bank. In fact, one of the most important functions of central banks like America's Federal Reserve and the European Central Bank is to control bank reserves, set reserve requirements and set the level interest rates. And of course, each of these forms of monetary policy can have important impacts on the levels of economic growth and inflation in the national economy. And that observation provides a great segue to our next module, the nuts and bolts of how monetary policy is used to control the money supply.
