Banking 4: Multiplier effect and the money supply How "money" is created in a fractional reserve banking system. M0 and M1 definitions of the money suppy. The multiplier effect.
Banking 4: Multiplier effect and the money supply
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- Let's think a little bit about what happened in the last video.
- I'll review again these different notions of money supply.
- And then let's talk about whether it's fair for people
- to think that they really have the money that they have
- So in the original video, after the crop was harvested,
- the farmers deposited 1,000 gold pieces in my bank.
- Then I lent out 900 of those.
- I had to keep some reserve
- in case those farmers wanted some of their money back.
- And I figured they would never need more than 10% at a time.
- I lend it out.
- They build a irrigate.
- You know, someone has a great idea to build an irrigation canal,
- so that more fields become usable and get access to water.
- So to build that irritation canal,
- they take those 900 gold pieces,
- and they pay a bunch of workers.
- Those workers now have the gold pieces.
- So they need some place safe to put it.
- They put it back in my bank.
- Now I get 900 gold pieces of deposits.
- I put 10% aside again.
- And now I lend out 810 gold pieces.
- Let's say I lend it out for an entrepreneur
- who wants to build a factory to build some type of tools
- that might make the apple harvest more efficient,
- or faster, or need less labor, or whatever.
- That entrepreneur takes those 810 gold pieces
- and pays the builder in the town.
- And then the builder now has 810 gold pieces,
- and then he gives the money back to me in my bank.
- Because I'm the safest place to keep it.
- I stop the chain there.
- You can keep going on and on,
- although there is some end.
- Notice that these values get smaller and smaller every time.
- And we'll do a little bit of math on that to figure out how far it can go.
- But then I take the builder's money,
- and I said, well, you know, this banking idea's a new idea to me.
- I'm just going to leave it all as reserves.
- I want to see how it all plays out first.
- So then we said, how much money is in the system?
- And it all depends on how you define money.
- And we made one definition of money called M0.
- In M0 we said -- we'll call this our narrowest definition.
- And this is literally, how much gold is there in the system.
- Or how much stuff is there in the system
- that could be immediately used for conducting a transaction.
- And I'm assuming, for the sake of this argument,
- that none of these players actually kept any gold in their pockets,
- or kept some cash in their wallets for a rainy day.
- Although if they did, we would included it in this calculation.
- I assume that everyone always deposits their gold with Bank of Sal.
- So when we did that calculation.
- -- there was this gold pieces of reserve that we had set aside at first.
- Then 90 here, oh, 900 here, sorry.
- And then 810 here.
- And if you add those up, you get 1,000 gold pieces in the system,
- which makes a lot of sense.
- Because we originally had about 1,000 gold pieces in the system.
- In the example, at least as I described it -
- we didn't have anyone discovering any new gold.
- nor was any a gold eaten or destroyed in some way.
- So it makes sense that there are 1,000 gold pieces.
- But then there's a more interesting question.
- If you went around the city,
- and you asked everyone how much money they had,
- they'll say, I have this much in my checking account with the Bank of Sal.
- If you ask me how much money I had,
- I would tell you how much is in my checking account.
- I actually have very little cash in my wallet right now,
- if any of you are thinking of mugging me.
- All of my money is in a checking account.
- So if someone asked me how much money do you have,
- I'd give that number.
- So if you went around the town,
- and you asked everyone, how much money do you have,
- and you added it up,
- you would get the total of the of their checking accounts.
- And so we had 810 gold pieces from the contractors,
- 900 gold pieces from the ditch diggers,
- and then 1,000 gold pieces from the farmers.
- Let's see, 1,900 plus 810.
- You get 2,710 gold pieces collectively in checking accounts.
- And since I'm the only bank,
- that's the total of my liabilities here.
- And we call that M1.
- And I'm calling these that for a reason
- because these are the actual words that are used
- by economists and our government officials.
- There's a couple of really interesting questions here.
- One is how did a 1,000 gold pieces get turned into 2,710.
- And then, this 2,710, does it represent real wealth,
- or was this some kind of weird shell game we played,
- and it represents some type of weird pyramid scheme?
- Well, how it got created -- we went through the mechanics, right?
- Every time I set a little aside, I lent some out,
- and then they deposited, etc. That's how it got created.
- The interesting question is, does it represent real wealth?
- The answer is it represents real wealth
- if each of these investments were real investments.
- So if this 900 gold pieces that were used
- to build this irrigation ditch or whatever it is,
- if that project actually does generate
- at least 900 gold pieces of future wealth
- -- essentially you could at least pay back the 900 gold pieces.
- It'll probably generate more if it's a good project.
- But if it generates at least 900 gold pieces of future wealth,
- then this is a real asset, right?
- This is a real asset.
- Likewise, if this factory really does generate
- at least 810 gold pieces of future wealth,
- if it really will allow us produce that much more apples or gold or whatever,
- this is a real asset here, right?
- So these people, this wealth, really does exist.
- This 2,710 gold pieces of quota quote wealth, really does exist
- as long as the projects that were the justification
- for borrowing the money actually do generate future wealth.
- So there's a couple of things to realize.
- There are not 2,710 gold pieces in this world.
- There only 1,000 physical gold pieces.
- But if these projects are real projects that are actually not mismanaged,
- they're not just some type of pouring-money-into-a-hole type of project,
- then we do have 2,710 gold pieces worth of wealth.
- And I really want to stress this point.
- Remember gold isn't wealth in of itself.
- Gold is used to represent wealth.
- You cannot eat gold.
- You cannot live under gold.
- Gold will not transport you someplace.
- Gold will not improve your health.
- It's something that's used to represent wealth.
- Sometimes people think it is wealth itself,
- and that's actually a misconception.
- So this 2,710 perceived gold pieces,
- that does represent real wealth,
- although it doesn't represent real gold pieces.
- And once again you might say, oh boy,
- this is some type of a shell game.
- But it's really not.
- As long as these investments are good investments.
- Remember, these are wealth generating investments.
- And notice, the money supply-- at least as we defined it with this M1
- -- it expanded to facilitate real economic production.
- So as long as this factory does generate wealth,
- or this irrigation ditch does generate wealth,
- then the money supply did not grow faster
- than the amount of wealth out there.
- So gold piece, you know, if before a gold piece bought an apple,
- now hopefully a gold piece will still buy an apple.
- In fact, and this is an important thing to realize,
- if these investments are very good,
- you're actually going to have
- -- let's say that we used to produce 1,000 apples per year.
- And notice apples are real wealth.
- Apples are something that you can consume.
- They will keep you living.
- And you can also view them as a form of investment,
- because by eating them you're able to do work.
- But anyway, let's say before all of this investment started happening,
- our economy could produce 1,000 apples.
- Now let's say that after this irrigation ditch was produced,
- instead of 1,000 apples, we go from being able to produce 1,000 apples
- to being able to produce 2,000 apples a year.
- And once again, a lot of wealth was created.
- Remember, we only took 900 gold pieces to build this.
- And all of a sudden we're doubling.
- We're able to produce another incremental 1,000 apples a year,
- which, in our old economy, was worth 1,000 gold pieces.
- So that actually will definitely pay off, right?
- You borrowed 900 gold pieces
- and this project will generate, not 1,000 gold pieces in total,
- it'll actually generate the equivalent of 1,000 gold pieces per year.
- It increases our production of 1,000 apples per year.
- And likewise, let's say that
- this factory takes us from 2,000 apples a year to 3,000.
- So let's think about it.
- Now in a given year, how many apples are being produced?
- We used to only have 1,000 apples being produced.
- Now we have 3,000 apples being produced,
- because these were really good investments.
- They really improved our productivity.
- So now, if you say everyone in the economy thinks that
- they have 2,710 gold pieces, or some equivalent of them,
- and we can produce 3,000 apples,
- now the money supply, 2,710, actually grew slower than our wealth.
- Let me let me draw that out.
- Before... Let's say money.
- I think it's really important to separate the two concepts.
- Money is used to transact wealth or represent wealth.
- It is not wealth in and of itself.
- And that has some important philosophical underpinnings to it.
- It'll probably make you live happier if you realize this difference.
- But before we had 1,000 gold pieces,
- before the banking and this fractional reserve system existed.
- And we had 1,000 apples of wealth per year.
- And I'll go more into the velocity of money.
- But after all this stuff happened later,
- we had 2,710 perceived gold pieces.
- This was our M1 definition.
- Our M0, the actual physical gold, was still 1,000.
- But how many apple do we produce a year?
- We now produce 3,000 apples.
- So notice the ratio of gold to apples actually improved
- And now, if you think about it,
- an apple is actually going to cost less gold.
- Before roughly you had one gold piece per apple;
- now you have less than one gold piece per apple.
- So because of our innovation, we actually experienced deflation.
- So you might have said, oh, boy,
- all of this money was created out of nowhere.
- This money doesn't exist.
- This will lead to inflation.
- But no, this is a very important point,
- because the money was put to work
- in actual productive investments that create wealth,
- that make the pie bigger, or the pie of apples bigger,
- we actually experience deflation.
- And our economy actually grew.
- And this was actually a very very positive example.
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