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How Saving & Investing Contribute to the US Economy

How Saving & Investing Contribute to the US Economy
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  • 0:00 Ways to Spend Money
  • 1:30 How Banks Create Money
  • 2:53 Loaning to Companies
  • 3:44 How Companies Are Owned
  • 5:02 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Ever wonder what happens to your money when you save it? Does it go sit in a bank vault, patiently waiting on you? What about investing? How do you determine a stock price? This lesson answers those questions.

Ways to Spend Money

Let's say that you suddenly got a check for $1,000. What would you do with it? If you're like a lot of people, you'd probably go out and spend a good chunk of it, whether on clothes, electronics, or a trip. However, if you didn't want to use it right away, you would be wise to hold on to it. But how would you hold on to it in order to make sure that it was available in the future? Chances are that you would deposit your money in a bank. After all, banks hold money for their customers. But, what do you think a bank does with that thousand dollars?

In this lesson, we will explore the answer to this question to see what a bank does with your money after you hand it to the teller and to see how companies can use your cash to make you even more money.

Saving Your Money

If you thought that a bank simply held your money in a vault until you were ready to use it, you couldn't be more wrong. Banks use the money you trust them with in order to make more money. Say that you deposited that money at your neighborhood bank. In fact, you could put it in a savings account or a certificate of deposit, a special account that you can only access after a certain period of time, and the bank is paying you an interest rate. The bank is paying you to keep track of your money - it's a pretty nice deal! You look at the bank owing you a thousand dollars whenever you want it, but the bank looks at it differently. To the bank, that's now an amount of money that they can loan out to other people or businesses.

How Banks Create Money

But how do banks use that money? In short, they use it to create new money. When you deposited that money in the bank, the bank is permitted by law to loan out a certain percentage of that money. It is required to keep a portion of deposited funds on hand at all times, known as the reserve ratio. However, the rest is available for the bank to use as it wishes. So let's take that $1000 and say that the reserve ratio is 10%. The bank has to keep $100 on hand but can loan that $900 out to anyone it wants to. Your $900 is suddenly paying for your little sister's car loan, your neighbor's mortgage, and even the new renovations at the restaurant down the street.

Of course, the bank makes a pretty penny off of this. Chances are that it is charging those other people several percentage points of interest, while only paying you one or two percent. That difference in interest rates is the bank's profit for the year. For example, if it makes $100 in interest off of every thousand dollars it loans out but only has to pay you 1%, or $10, to keep your thousand dollars, then the bank has made $90. Considering that even the smallest banks can loan out millions of dollars a year, it's easy to see how banks can make so much money.

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