Primary Reserves

Categories: Econ

You did the lemonade stand in elementary school, the bake sale in high school, and the "special" bake sale in college. Time for the big guns: opening a bank.

The first thing you need to know about a bank: primary reserves. Primary reserves is the bucket of money that you need, at minimum, to run your bank. Even if it’s an online bank, you’ve gotta pay your staff, and pay for web hosting. Some of your primary reserves you’re not going to be allowed to touch. Those are the required reserves, required by the Fed.

While you’re trying to get your bank up and running, it might seem silly to have money just sitting there, but you'd better do it, because you’ll get in trouble with the law otherwise. Plus, if everyone tries to cash out at the same time, you’ll have some money on hand to dish out to them, since it won’t be all tied up in loans.

Say you get your first ten customers, each depositing $2k. That’s $20k in your bank. You have to deduct the required reserves, which is 20%. That means you have to keep $4k in required reserves...no touchie. Then you have to subtract your operating costs. Then, what you have left...you can loan out to people. You’ll make money off the interest they’re paying you...if they pay you. Better check them out first.

Related or Semi-related Video

Econ: What are Reserve Requirements, Exc...9 Views

00:00

And finance Allah shmoop What our reserve requirements excess reserves

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and the multiple expansion of deposits in the US The

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Fed a k a The Federal Reserve a k a

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The central bank keeps a watchful eye on reserve banks

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who keep a watchful eye on commercial banks So yes

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

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royal family well then reserve banks or dukes and duchesses

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and the commercial banks are aristocrats The Fed requires banks

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to meet reserve requirements also known as the cash reserve

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ratio which is the amount of money banks have to

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keep on hand Handy Dandy Ready for quick withdrawal Why

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is this a rule Well part of what spawned the

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

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of runs on banks from banking panics A run on

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the bank is when everyone rushes to their bank and

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demands all of their deposits back Now the thing is

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one of the boys banks make money is by lending

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out your money to other people Yep your money Your

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deposit for banks to make the most money possible Well

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they would lend out as much money as they could

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which in theory would be all of it But then

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that leaves you the deposit or without cash when you

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need it The Fed wanted runs on banks to be

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a thing of the past which they pretty much are

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now so they made these reserve requirements The money that

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banks are allowed to loan out are called the excess

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reserve For instance a bank may be required to have

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say ten percent of its total money on hand which

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would mean the remaining ninety per cent of the money

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is excess reserves which banks can lend out to turn

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

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of deposit Well multiple expansion of deposits is the theory

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that each deposit into a bank creates additional money made

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from excess reserve deposit as they are well continuously lent

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out by banks and then re deposited in other banks

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

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economy called the Deposit Expansion Multi a buyer which estimates

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the maximum amount of money that the Fed could expect

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in deposit injection into the economic system that you know

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they were kind of creating and managing Well this is

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how the Fed the controller of the money supply decides

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how much new money toe pump into the economy and

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the maximum effect they could possibly expect from that injection

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

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bank has a ten percent reserve requirement leaving ninety percent

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in excess reserves Well when that money is lent out

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

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

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dollars check into your bank account in your bank says

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would be and it lends out ninety percent of it

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which is eighteen hundred box right that other two hundred

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dollars they were going to keep on hand for reserve

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

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

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Everest climber Chris deposits that eighteen hundred dollars into his

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

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your bank and they do the same thing that bank

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lens Ninety percent of the eighteen hundred dollars which is

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sixteen hundred twenty bucks The remaining ten percent that hundred

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

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requirements Well Climate Chris Bank then lends out six hundred

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

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

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

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bank account does Yep same is your bank and same

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

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ninety percent of the money she deposit which is a

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fourteen hundred forty eight dollars to Dan the Man and

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so on Under this system and initial deposit actually grows

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providing more value than the initial amount deposited Its multiplied

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each time money is loaned out and then re deposited

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only ninety percent That deposit gets turned into a new

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loan Well we could keep taking ninety percent of the

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deposits The maximum amount thanks can loan out from that

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deposit until the amount loaned out deposited gets just any

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words No more counting anymore So you still have that

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two thousand dollars in your bank account that belongs to

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you Meanwhile climate Chris has eighteen hundred and you can

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spend a teacher Tina has sixteen twenty that she can

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spend and it all came from your initial deposit Thank

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you very much Well how Khun to Grand that was

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in your bank account multiply into additional value that other

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people can use in the economy But we told you

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that multiple expansions of deposits was magic It literally expands

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the money supply Will remember that deposit expansion multiplier we

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

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amount of money and initial injection of a deposit like

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your two grand can be expected to create Will the

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deposit expansion multipliers just calculated as one divided by the

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

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one or ten we can use the deposit expansion multiplier

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

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the money supply under this setting to figure out how

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much a deposit expanding the money supply We just multiply

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the expansion multiplier by the initial excess reserves On our

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scenario the reserve requirements ten percent which gives a deposit

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expansion multiplier of ten Then we take that excess reserves

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from the initial deposit You know that ninety percent chunk

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of money that was created into the first loan for

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climate Chris by your bank and I was eighteen hundred

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

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by ten So ninety percent ofyour deposit was loaned out

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on deposit to Climate Chris and I sounded out blown

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out positive Tina and I pretended I was loaned out

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and positive Dan the Man and so on So if

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

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while then it means the money supply was expanded by

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eighteen thousand dollars That means assuming a reserve requirement of

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ten percent for all commercial banks while your initial deposit

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of two grand expanded the money supply nine times to

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be eighteen thousand dollars in the economy Yes you Khun

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

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expansion superhero why do we care about multiple expansion of

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deposits Well the Fed is in charge of keeping the

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economy healthy One major way of doing that is by

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maintaining the money supply you can think about That is

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a doctor and the economy is a patient with the

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money Supply is well the blood pressure A low blood

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pressure like a low money supply means multiple expansion of

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

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the economy which results in less spending and slower economic

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

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

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it before in history where a government just starts printing

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more and more money without the corresponding economic growth and

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what happens well hyperinflation prices of everything skyrocket and money

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becomes almost useless People lose trust in the system And

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

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

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carton a month later Six thousand Some places have faced

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hyperinflation of like three thousand percent a year or more

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

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like blood pressure stable which means it needs to be

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not too high not too low Well when the Fed

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raises interest rates it essentially lowers the demand for loans

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It lowers the amount of access reserve loaned out and

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that whole process slows the growth of the money supply

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from slower expansions of deposits When the Fed lowers interest

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

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multiple expansion of deposits to grow the money supply well

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Besides interest rates the Fed can tinker with things like

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stimulus packages and other strategies to expand or contract the

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

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of crazy All right so now you know money does

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not grow on trees but well it does grow out

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

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