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The Multiplier Effect and Its Importance

Every day, millions and millions of dollars changes hands in America’s banks. Many people think that those dollars merely go into a vault to be taken out when you want them. In actuality, that money is lent out. Well, not all of that money. Some, typically about 15 percent, is not lent out, by Federal Reserve requirements. What is lent out, however, will end up as somebody’s income, which they will either spend or save. What they save goes into a bank, continuing the effect. What he spends becomes yet another person’s income, which will, again, be either saved or spent. This process is called the Multiplier Effect. The result is, that every dollar that you have saved in your local bank, is actually backing several dollars in the economy. Exactly how much is dependent upon how much the Fed dictates that the banks must keep in their reserves. Importantly, if all of a bank’s constituents tried to take all of their money out of all of the banks at the exact same time, a situation known to a single bank as a run, there would be only a fraction of the money demanded by the people. Picture that scene in It’s a Wonderful Life, where everyone wants to draw their money out of the Building and Loan, when people doubt the security of their money. George Baily says, paraphrasing, “Your money isn’t in here, Keynes, it’s in Von Mises’s house, and in Hayek’s house, and it’s keeping Von Wieser afloat after his house burned down.” But when the people aren’t satisfied, and still want their money, there is none to give. This is when his wife shows up with the extra money from the honeymoon. This is in fact a perfect example as to what the Federal Reserve does. It provides Liquidity during times when there is distrust in the security of a bank. When a bank is in dire straits, the Fed can buy Federal Bonds and use the money to loan out to banks what they need. When people know they can get their money, they stop asking for it.

This is what the Federal Reserve did under Benjamin Strong up until 1928—one year before the Great Depression. When he died, however, Washington seized control over far more of the Federal Reserve. (Which, of course, would later end in disaster.) When, in 1929, the stock market floundered and The Bank of America went under (a regular New York city bank with a famous name, that many thought it was THE BANK OF AMERICA!), the Fed could have intervened. In fact, when the system was created in 1913, this was exactly what it was commissioned to do. But, when the people clamored for their money in 1929 and 1930, there was none to give. The Federal Reserve did not provide the much-needed money to the American banks when they needed it most. It remained silent. The Federal Reserve’s failure in this area led to the money supply falling by approximately 30 percent. As Milton Friedman, the great Monetarist, would later put it, “The slow throttling turned to strangulation.” The Great Depression is a perfect example of what happens when the Multiplier Effect works backwards. When people draw large amounts of money out of a bank they are, in effect, pulling much more out of the economy, straining the other banks as well. This chain reaction led to the monetary supply decreasing by nearly a third from 1929 to 1933. There was less money to keep the system going, and in fact, it went in reverse, taking industries and jobs with it; leading to further calamity in the stock market. This led Ben Bernanke, former chair of the Federal Reserve, to say, “Regarding the Great Depression: You're right, we did it. We're very sorry… we won't do it again.” Let us hope, for the sake of America, that they don’t.


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