Money Creation by Banking System Video Lecture | SSC CGL Tier 2 - Study Material, Online Tests, Previous Year

today's video lecture is going to
explain how money is created in a
fractional reserve banking system a
fractional reserve banking system is
when banks are required to keep only a
fraction of their total deposits on
reserve any excess reserves or deposits
that exceed that which is required can
be loaned out to borrowers who can
invest and spend the money in the
economy as we'll see in such a system a
particular amount of money can be
multiplied through the creation of new
money as it is loaned to borrowers and
spent by those borrowers on goods
services or new investments in capital
in order to understand how money is
created through a fractional reserve
banking system we're going to start with
the assumption that there is a business
and industry in which goods and services
are produced so in our upper left hand
corner here we have our businessman and
his factory now this businessman employs
workers in the production of goods and
services upon the sale of this factories
output these workers will be paid so as
we see here we have a thousand euros
which this factory owner is earned from
the sale of its goods and services and
is going to pay to its workers these
workers will spend some of this money
and they will save some of this money
but ultimately any money spent or saved
by the workers at this factory will end
up being deposited into hypothetical
Bank a so Bank a is a savings
institution at which the workers in this
factory and the people who receive the
money that they spent from the
production of their goods and services
are saving their money so as you see
there is an increase in bank a's total
reserves by 1,000 euros now we have to
ask the question what is the reserve
requirement in this economy in other
words of this 1,000 euros how much is
required to be put into reserve let's
assume that in Europe today the ECB of
the European Central Bank has set a
reserve ratio of 0.2 this means that 20
scent of all commercial banks deposits
must be kept in reserve at the European
Central Bank so we have a thousand euros
has been deposited from the workers
earning the money due to the production
of the goods in this factory of this
thousand euros 200 euros must be kept on
reserve at the bank so we'll move 200
euros over here now this leaves 800
euros which this commercial bank has in
its excess reserves the question is what
will the commercial bank wish to do with
these 800 euros of reserves now the
savers at this Bank are earning interest
on their savings in order to pay the
savers interest bank a must earn
interest on their reserves so bank a has
800 euros that it wants to loan out so
that it can charge interest to a
borrower now the availability of this
financial capital will not surprisingly
attract new capitalists so let's assume
that another entrepreneur comes in
borrows 800 euros from Bank A's excess
reserves in order to pay for the
production of goods in his own Factory
so this 800 euros will go towards a
production of goods and of course the
employment of more workers 800 euros
will cover the production costs of this
new factory will be paid to the workers
who will then spend some and save some
and ultimately the 800 euros will end up
being deposited into other banks in the
economy represented by Bank B so as we
see the 1000 euros earned by the workers
in the first factory will ultimately
lead to an additional 800 euros of money
being created through the fractional
reserve banking system Bank a is able to
lend out 800 euros of the initial 1000
euros deposited to another businessman
who pays his workers who will spend some
of that money which will go into other
banks in the economy as reserves now we
have 800 euros in Bank B with the
reserve requirement of 0.2 bank B must
set aside 160 euros into its required
reserves so let's count out 160 euros
here there is 100 and we've broken this
up
and it some chunks that's three-fifths
of another hundred that's 160 euros now
this leaves 640 euros in Bank B which
are excess reserves what is bank B going
to do with it 640 euros of excess
reserves of course it wants to loan this
money out so that it can charge interest
to borrowers and earn a profit by paying
its savers a slightly lower interest
rate the availability of excess reserves
in Bank B attracts new borrowers so
we'll have yet another borrower join the
market borrow the 640 euros use this
money to pay for the production of goods
and services and for the employment of
yet more workers who will get paid the
money that the capitalist is borrowed
and ultimately the 640 euros will you
predicted it'd be deposited into yet
more banks in the banking system now
there are 640 euros in the banking
system that were created through Bank
B's lending to another borrower with the
required reserve of 0.2 128 euros must
be added to bank sees required reserves
so we'll take another hundred out and
another piece of this here now we have
128 euros and required reserves leaving
Bank C with 512 euros in its excess
reserves of course this process will
continue bank C will lend out its excess
reserves to get more borrowers who will
spend that money on the production of
goods employ more workers who will spend
that money and it will ultimately be
deposited in yet another Bank all along
the way more money is being created now
how can we actually say money is created
even though this whole process started
with an initial deposit of just 1000
euros in fact the money supply in a
nation is not simply the base of
currency that exists rather it is a
multiple of that monetary base in this
economy there's only 1000 euros of hard
currency however a nation's money supply
includes all the money that exists in
checking accounts and savings accounts
in the banking system therefore with the
reserve ratio of zero
point2 there is actually a multiplier
effect when there is an initial change
in deposits in the banking system in
this economy to determine the total
change in the money supply that resulted
from the initial change of 1,000 euros
we know we must calculate what is called
the money multiplier the money
multiplier is found by dividing one by
the reserve ratio in our economy the
reserve ratio is zero point two so the
money multiplier is one divided by zero
point two or five this means that even
though there's only 1000 euros of hard
currency in this economy the total money
supply can be a multiple of that 1000
euros due to the fact that commercial
banks are only required to keep 20
percent of their total deposits on
reserve at any given time money is being
created through the lending and
borrowing from banks excess reserves and
the new deposits that are created by any
money that is lent and borrowed the
total change in this money supply
following the 1000 euro change in
deposits at the beginning of this
process will therefore be 1,000 euros
times the money multiplier of five which
gives us 5,000 euros now this is a
little bit misleading one assumption
we've made is that the initial change in
checkable deposits or the change in the
bank's reserves of 1,000 euros was not
already part of the nation's money
supply in fact if we take into account
that the original entrepreneur used to
pay for the manufacture of his goods and
to pay his workers was already part of
the money supply then the actual change
in the money supply will be 5,000 euros
minus the original one thousand so we
have to actually subtract out the
initial deposit of 1,000 euros because
we have to assume that the original
entrepreneur got that money from
somewhere and it was probably already
part of the nation's money supply so as
we have
schon when there is an initial change in
deposits in a commercial bank the
ultimate change in the money supply will
exceed that change in deposits since
commercial banks are only required to
keep a fraction of their total deposits
on reserve 80% of every euro deposited
into Bank a could be lent out spent or
invested earned by somebody else in the
economy deposited into Bank B increasing
that banks required reserves and its
excess reserves since banks can always
lend out their excess reserves money is
being created along the way here the
total change in the money supply will be
a multiple of any initial change in
deposits in a commercial bank now this
raises a question what if the initial
change in deposits comes not from a
private investor as we saw in this
activity rather from an action taken by
the central bank let's assume for
instance that rather than the increase
in the deposits of Bank a coming from a
business man's business activities
instead the supply of reserves in Bank a
increases because the european central
bank buys bonds from commercial banks
now what's the difference between a bond
purchase which was explained in a
previous video lesson and its effect on
the money supply how is that different
then when the initial change in deposits
in the banking system comes from private
investment from an entrepreneur in fact
as you may recall money held at a
central bank is not considered part of
the money supply therefore when the
European Central Bank buys bonds which
is an open market expansionary monetary
policy the supply of excess reserves
will increase just as it did before by
1000 euros at the same time the required
reserves will once again increase by 20
percent of 1000 euros or 200 euros
leaving 800 euros of excess reserves for
Bank a to loan out however the
difference now is that the change in the
money supply will be equal to the
initial change in deposits multiplied by
the money multiplier so in this case the
total change in the
supply will equal 1,000 euros times the
money multiplier 5 which is 5,000 euros
now why when the private individuals put
1000 euros into the banking system did
the money supply only creased by 4000 as
opposed to when the central bank buys
bonds does it increase by 5,000 this is
because money held at the ECB it was not
counted in the nation's money supply
therefore the central bank's purchase of
government bonds increases the money
supply by more than when a private
spender or saver puts money into the
nation's banking system so this is the
conclusion of our lesson on the
fractional reserve banking system and
how money is created through a system in
which commercial banks must hold only a
fraction of their total deposits on
reserve when a bank loans out money that
is saved in its institution it creates
new money for this reason the total
change in the money supply resulting
from an initial change in deposits in a
commercial bank will be a multiple of
the initial change in deposits the money
multiplier is always 1 divided by the
reserve requirement so we can learn this
tool here the money multiplier is 1
divided by the reserve requirement
multiply this by the initial change in
deposits and you will get the total
change in the money supply but keep in
mind if the initial change of deposits
comes from an increase in savings from
private spenders or savers then the
initial change in deposits cannot be
included in the total change in the
money supply however if the initial
change in deposits comes from a purchase
of bonds by the central bank then the
money supply will increase by the money
multiplier times the initial change in
deposits