McDonough Ratio

And finance Allah shmoop What our reserve requirements excess reserves

and the multiple expansion of deposits in the US The

Fed a k a The Federal Reserve a k a

The central bank keeps a watchful eye on reserve banks

who keep a watchful eye on commercial banks So yes

there's a whole hierarchy If the Fed is like a

royal family well then reserve banks or dukes and duchesses

and the commercial banks are aristocrats The Fed requires banks

to meet reserve requirements also known as the cash reserve

ratio which is the amount of money banks have to

keep on hand Handy Dandy Ready for quick withdrawal Why

is this a rule Well part of what spawned the

Fed into existence in the first place was a siri's

of runs on banks from banking panics A run on

the bank is when everyone rushes to their bank and

demands all of their deposits back Now the thing is

one of the boys banks make money is by lending

out your money to other people Yep your money Your

deposit for banks to make the most money possible Well

they would lend out as much money as they could

which in theory would be all of it But then

that leaves you the deposit or without cash when you

need it The Fed wanted runs on banks to be

a thing of the past which they pretty much are

now so they made these reserve requirements The money that

banks are allowed to loan out are called the excess

reserve For instance a bank may be required to have

say ten percent of its total money on hand which

would mean the remaining ninety per cent of the money

is excess reserves which banks can lend out to turn

a profit Now here's where the magic happens Multiple expansion

of deposit Well multiple expansion of deposits is the theory

that each deposit into a bank creates additional money made

from excess reserve deposit as they are well continuously lent

out by banks and then re deposited in other banks

There's a literal multiplier effect that ripples outward into the

economy called the Deposit Expansion Multi a buyer which estimates

the maximum amount of money that the Fed could expect

in deposit injection into the economic system that you know

they were kind of creating and managing Well this is

how the Fed the controller of the money supply decides

how much new money toe pump into the economy and

the maximum effect they could possibly expect from that injection

of money into the system For instance let's say your

bank has a ten percent reserve requirement leaving ninety percent

in excess reserves Well when that money is lent out

whether to a consumer or a business it's deposited into

another bank eventually So let's say you deposited two thousand

dollars check into your bank account in your bank says

would be and it lends out ninety percent of it

which is eighteen hundred box right that other two hundred

dollars they were going to keep on hand for reserve

requirements Okay so let's say that eighteen hundred dollars is

linked to a climber Chris who's keen on climbing Mount

Everest climber Chris deposits that eighteen hundred dollars into his

bank account Clymer Chris's bank says would be just like

your bank and they do the same thing that bank

lens Ninety percent of the eighteen hundred dollars which is

sixteen hundred twenty bucks The remaining ten percent that hundred

eighty is kept at Climber Chris's Bank to meet reserve

requirements Well Climate Chris Bank then lends out six hundred

twenty dollars to teacher Tina who's running short on school

supplies and gas Teacher Tina What's that Sixteen twenty into

her bank account And you can guess what teacher Tina's

bank account does Yep same is your bank and same

as Climber Chris's bank and teacher Tina's bank lends out

ninety percent of the money she deposit which is a

fourteen hundred forty eight dollars to Dan the Man and

so on Under this system and initial deposit actually grows

providing more value than the initial amount deposited Its multiplied

each time money is loaned out and then re deposited

only ninety percent That deposit gets turned into a new

loan Well we could keep taking ninety percent of the

deposits The maximum amount thanks can loan out from that

deposit until the amount loaned out deposited gets just any

words No more counting anymore So you still have that

two thousand dollars in your bank account that belongs to

you Meanwhile climate Chris has eighteen hundred and you can

spend a teacher Tina has sixteen twenty that she can

spend and it all came from your initial deposit Thank

you very much Well how Khun to Grand that was

in your bank account multiply into additional value that other

people can use in the economy But we told you

that multiple expansions of deposits was magic It literally expands

the money supply Will remember that deposit expansion multiplier we

mentioned earlier It's how the Fed can measure the maximum

amount of money and initial injection of a deposit like

your two grand can be expected to create Will the

deposit expansion multipliers just calculated as one divided by the

reserve requirements sonar case That's one By the by point

one or ten we can use the deposit expansion multiplier

to see how much money you're too grand Deposit expanded

the money supply under this setting to figure out how

much a deposit expanding the money supply We just multiply

the expansion multiplier by the initial excess reserves On our

scenario the reserve requirements ten percent which gives a deposit

expansion multiplier of ten Then we take that excess reserves

from the initial deposit You know that ninety percent chunk

of money that was created into the first loan for

climate Chris by your bank and I was eighteen hundred

bucks right So you're going to multiply that eighteen hundred

by ten So ninety percent ofyour deposit was loaned out

on deposit to Climate Chris and I sounded out blown

out positive Tina and I pretended I was loaned out

and positive Dan the Man and so on So if

we assume the bank's loaned out ninety percent of stage

while then it means the money supply was expanded by

eighteen thousand dollars That means assuming a reserve requirement of

ten percent for all commercial banks while your initial deposit

of two grand expanded the money supply nine times to

be eighteen thousand dollars in the economy Yes you Khun

tell everyone you're welcome Okay So besides feeling likea money

expansion superhero why do we care about multiple expansion of

deposits Well the Fed is in charge of keeping the

economy healthy One major way of doing that is by

maintaining the money supply you can think about That is

a doctor and the economy is a patient with the

money Supply is well the blood pressure A low blood

pressure like a low money supply means multiple expansion of

deposit is low which means there's less money flowing through

the economy which results in less spending and slower economic

growth Yeah no likey Blood pressure that's too high like

a high money supply isn't good either though we've seen

it before in history where a government just starts printing

more and more money without the corresponding economic growth and

what happens well hyperinflation prices of everything skyrocket and money

becomes almost useless People lose trust in the system And

oh that's so not good for the economy So that

two dollar milk and now it's one hundred dollars a

carton a month later Six thousand Some places have faced

hyperinflation of like three thousand percent a year or more

Well the feds jobs to keep the economy's money supply

like blood pressure stable which means it needs to be

not too high not too low Well when the Fed

raises interest rates it essentially lowers the demand for loans

It lowers the amount of access reserve loaned out and

that whole process slows the growth of the money supply

from slower expansions of deposits When the Fed lowers interest

rates it's trying to increase demand for loans encouraging the

multiple expansion of deposits to grow the money supply well

Besides interest rates the Fed can tinker with things like

stimulus packages and other strategies to expand or contract the

money supply They do all kinds of things They're sort

of crazy All right so now you know money does

not grow on trees but well it does grow out

of your bank account So let's go deposits him though