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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