Source: Image of bank notes, public domain, http://en.wikipedia.org/wiki/File:Billets_de_5000.jpg, Image of check, creative commons, http://en.wikipedia.org/wiki/File:Sweet_success.jpg
Hi. Welcome to macroeconomics. This is Kate. This tutorial is on the reserve requirement. As always, my key terms are in red and any examples are in green. In this tutorial, we'll talk about how we can classify money according to how liquid it is into M0, M1, and M2. You'll see that the Federal Open Market Committee is the organization in our country who manages and make decisions about the supply of money. And we'll talk about how the reserve requirement is one of the tools that the Fed has, or the FOMC has, which allows them to control how much money banks must keep on reserve.
Finally, we'll see that the money multiplier shows us how much money can be created through loans. So just as a quick reminder here. Money serves three functions. It's really anything that serves as a medium of exchange, helping us to get the things we want, a store of value, anything that we can store and retain its value and access later, and a unit of account. Once things is an acceptable form of payment, we can use it in helping to make transactions, and do record keeping.
So what is money? Most people think of money as bills and coins. But if money really is anything that allows us to get what we want, isn't it checks or debit cards? What else is it? So let's talk about liquidity for a minute. Depending on how easy or difficult it is to spend a certain type of money, we can classify it accordingly. So some forms of money, like physical cash, are really easy to go out and spend right now. Probably the easiest kind of money to spend right now. So that's an extremely liquid form of money.
But other kinds of money, like the money I have right now in my savings account, that's going to involve a few more steps for me to be able to spend it. So this idea of liquidity is what we're talking about here. M0, M1, and M2 deal with liquidity. M0 is the most liquid form of money. It's our narrowest definition of money and just includes physical cash in circulation.
M1 takes one step further. So it includes M0, but now it includes checking accounts. So it's still very liquid. I can write a check on my checking account. I can swipe my debit card on my checking account. But M2 is M1 plus M0 plus all the time deposits. So this is the broadest definition of money and it's the least liquid. So things like savings accounts, money market mutual funds, those are what we refer to as time deposits.
So here are the formal definitions for you that are your key terms. M0, the narrowest definition of money, just including the stock of physical currency. M1, like we said, includes those demand deposits, so checking account balances, plus M0. And M2 includes the time deposits plus M1.
We're talking about these different parts of our money supply because it's the FOMC, or the Federal Open Market Committee, that manages this money supply. So they're part of the Fed and they meet eight times a year to manage our nation's money supply. So what they do to try to control our M0, M1, and M2, they have several tools-- the reserve requirement, open market operations, the Fed funds market, and the discount rate. Each of these tools is a separate tutorial. This tutorial though is on the reserve requirement so let's get into that now.
So how is it that banks make money? We know that if they just stored it for us, they wouldn't profit. When we deposit money into a checking account at a banker, we can demand that at any time. However, banks make money by lending out a portion at least of our deposits and then charging interest. So for every dollar held in the vault or in their reserves, there could be multiple dollars in multiple checking accounts on which we have the ability to write checks. It's called a fractional reserve system.
It sounds like it wouldn't be OK, but think about it. What are the chances that everyone will show up at your bank or all the ATMs at your bank and demand all of their money? As long as the demand for cash on any given day is less than the cash that the bank is actually holding in reserve, this system's just fine. It allows banks to make more loans and then for them to earn more interest. This is how banks create money in our economy, believe it or not.
If banks, though, lend out too much of our money or if people show up demanding all the cash in their accounts then we get to the point where the bank can't meet the demands and the bank would fail or go bankrupt. This used to happen a lot in our country's history back in the day. So the Fed came around and started regulating how much of these reserves the banks have to hold in their vaults or at the regional Fed bank.
So reserves are the portion of deposits required to be held by a bank. They are usually kept to maintain reserve requirements and those are set by the Fed. So this reserve requirement is the required amount of depository liabilities as set by the Fed that a bank must hold. It's usually quoted as a percentage so like 10% is the reserve requirement. I'll run through some examples for you.
So if I deposit $1,000 right now into my checking account and the reserve requirement that the Fed has set is 10% that means that my bank has to hold on to $100 of that $1,000 as reserves. They can lend out the rest or $900. If the reserve requirement goes up, the bank can't lend out as much money. So if it rises to 20%, they'd have to hold on to $200 and could only lend out $800. If it falls then they can lend out more money. If it fell to 5%, they'd have to only hold onto $50 as reserves and could lend out $950. These changes in the reserve requirement change the ability of banks to make loans.
So lending equals money creation, believe it or not, in our economy. So I want you to walk through this example with me. So when a bank makes a loan for money that I've deposited, they are creating money. Because I still have the ability to write a check, or demand that cash that I've deposited. But if they loan out some of that money someone else now has money that they didn't have before. In that way, money is created.
So if we stick with a reserve requirement of 10% and let's just start with you take out a loan for $1,000. OK boom. You have $1,000 you didn't have before. That's money. If it's physical cash, that's now money in M0. You go and you deposit it into your checking account. Now it's in M1. What's your bank going to do? If the reserve requirement is 10% your bank lends out let's say $900 to somebody else and holds on to their required $100.
That person who got the $900 now deposits their money into a bank and that bank lends out $810 or 90% of what they're allowed to loan out. They hold on to the 10% of $90. And the process continues. What's gone on so far is that your initial deposit to the bank from that loan have caused the money supply to increase by that much, $2,710 so far. It's going to continue. As long as banks are lending out a portion of the money this will continue.
How do we figure out how much it continues? What we do is we find the money multiplier. The money multiplier is just 1 divided by the reserve requirement. So in this case, the money multiplier is 10. That tells us that if we take our initial cash deposit or our initial loan-- so $1,000 in M0-- will lead to a potential $10,000 increase in checkable deposits in M1. So 1,000 times our multiplier of 10 gives us the $10,000.
So here's your definition for the money multiplier. It's the increase in the money supply resulting from the ability of banks to loan deposits. It's equal to that one over the reserve requirement ratio, the reserve ratio. What kind of impact does this have? Let's look and see. What if the reserve requirement were 50% instead of 10%? If we go through the exact same process here, you can see that the bank can't lend out as much money.
So they lend out $500 and hold onto now more money. That person, though, does have money that they didn't have before and they deposit it. But, again, now each time there's less and less money available for the bank to re-lend out because they have to hold on to more of it. If this process continues and we use our same equation, the money multiplier is 2. So my initial $1,000 deposit can only create $2,000.
If there was actually a reserve requirement of 100% there is no ability here to create money. There's no multiplied effect. So the idea is the greater the supply of funds that banks can loan out, the greater their ability to increase our money supply. So if the Fed wants to increase the money supply they make it easier for banks to make loans and they lower the reserve requirement. If they want to decrease the money supply, or contract it, they do the opposite. They raise the reserve requirement.
So in addition to giving the Fed the power to control of the size of M1, it's also been a very powerful tool by helping to prevent bank runs, because banks have to report about these reserves every single day. And it gives consumers hopefully the confidence that their bank will, in fact, have the money that they can demand at any time.
In this tutorial, we talked about how we can classify money according to liquidity. We talked about how the FOMC is who manages and makes decisions about our supply of money. I told you how the reserve requirement-- that's what we really focused on-- is one of the Fed tools that allows them to control how much money banks must keep on reserve. And the money multiplier, 1 over r, shows us how much money can actually be created through loans. Thanks so much for listening. Have a great day.