Overview of Fractional Reserve Banking Big picture of how money enters circulation and how lending can increase the money supply
Overview of Fractional Reserve Banking
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- What i wanna do with this video is to give an overview og how money is created in most market based economies
- an even a bit of a discussion of what really is money, and we can go to much more depth in future videos
- in most market based economies right now there is a central bank, which is essentially the actor,
- they do many things, they often will be the regulatory agency as well
- but their main role is to have the right to print money, and to put that money into circulation
- i'll rely heavily on the model of the US and the Central Bank
- The central bank in some countries is formally part of the governement
- in other countries, its pseudo-independant. In the US its more pseudo independant
- Although obviously, closely connected with the government, the UD federal reserve
- a lot of the leaders are appointed by the government, its excess profits go back to the government, so obviously
- it have very close ties to the goverment. But when the central government decides to print money
- it literally can just create physical money, or it can create electronic money, which has the same effect
- So let's say the central bank goes out there, and prints 3 physical dollar bills
- now it has to figure out, how does it get it into circulation, how does it get it into the economy?
- It does not just put it into a helicopter and drop it out!
- Sometimes, in certain circumstances, is can lend this directly to bank, certain types of banks
- but the typical way that this enter circulaiton, is that the central bank will use this newly created money
- to go out into the open market and buy securities and they typically buy safe securities like government debt.
- So they will go out there and put this into circulation, and in exchange they are buying securities form the open market
- So these securities will go to the central bank. so there are securities, or bonds
- And once they do that, then whoever had these before, whoever was the owner of these securities before
- Now they have these dollarbills, and they can either directly spend these dollars
- or they can deposit these dollarbills in the bank. If they spend the dollars, then whoever they gave those bills to at some point would want a deposit in a bank
- So someway, by buying these securities, someone now has these dollarbills, and they will deposit them in a private bank.
- So let's draw that. So right over here is a private bank. And now it has the dollarbills.
- It has the reserves. Now, that's not the end of the story
- This money can now be lend and this is key because this is typical in most market economies
- where they have fractional reserve lending.
- franctional reserve lending
- which is a bit strange, because you are telling the people who just deposited these money here
- that you can go at any time and you can take this money out.
- We've got this money for you, you can trust us, you don't have to be paranoid about what's gonne happen with this money
- But the reality is that this bank i allowed to keep only a fraction of these reserves and lend the rest out.
- In order for the system to not be super fragile, the central bank then also insures these banks
- I just want to show you how this money is created in the fractional reserve lending system
- So this bank over here says, we'll have to keep a little bit of these reserves in case these guys come the probability of all of my
- customers come on the same day and ask for all of my money is low. I just have to keep a little bit for whoever does come, and the rest i can lend out
- Eventhough i promised everyone that all of they money is always available. So they lend it out to whoever needs that money
- who looks like a decent risk. And those people might not spend it emediately, they would deposit it into a bank
- Or they might spend it immediately, they buy a factory or car or something.
- and whoever they bought those things from will now have this money and they will deposit it into a bank
- So this newly lend money will now end up in a bank
- Also end up in a bank
- Now this can it can also only keep a fraction of the reserve and lend out the rest
- And for simplicity in most banking systems, they only have to keep about 10 percent of the reserves in house and lend out the rest
- But overhere i'm keeping much larger reserves just for the sake of making it easy to draw this diagram
- So this bank overhere may decide to keep this dollarbill and could lend this one over here out
- And once again, when it lends that dollarbill, it will end somehow and the person they lend it to may keep it in a bank temporarily or they might immediately buy
- something, and when they buy something it will eventually end up in a bank because the person they
- bought something from will deposit that money, and so it could end up in another bank.
- This is interesting and in future videos we will go into more of the math of exactly how much money is being created
- Its an interesting mathematical problem - actually its the sum of an infinite series and you can look it up if your'e interested.
- But the basic idea here is that even though the central bank printed 3 units of base dollars, there a lot more money in the system
- You have this guy who made this deposit thinks he has 3 dollars, this person thinks he has 2 dollars and this person thinks they have on
- So in this example we have 1,2,3,4,5,6 - 6 dollars
- So we have 6 dollars in this system
- 6 dollars
- And you might say "is this really money"?
- This guy thinks he has it but he's not using it if he had to use it he would have to withdraw it and then the bank would be able to do this
- And this is where checking accounts is really important
- I'm assuming that these are on-demand checking accounts
- So this guy, the reason why he's not going to withdraw this money is that he can still use it as money by writing checks
- So this guy says ok this is all the money i have, and he decides that he really needs to buy and apple and that apple costs 1 dollar
- He does not have to withdraw this dollar out of the bank, he can write a check
- So right now he has claims to all 3 of these dollars. He can write a check to the apple vendor, so 1 dollar
- he writes a check, gives it to the applevendor, and will get the apple so his check is acting as money
- and now the applevendor will have the rights to one of these apple's overhere
- and how the applevendor can write a check so this dollar never has to leave the banking system
- But because of checks it is essentially enabling these transactions to occur, so its still an
- enabling, it is still acting in some forms of money because the rights to it can change
- even though it is sitting out here and has been lend
- or you can say it is enabling the writing of checks that are acting as some form of money
- And the whole reason i wanna do this is to show you that the amount of money in circulation
- is not essentially in the central banks control
- They can definitely decise, hey i'm gonna print money, buy securities, put in into circulation
- or if they wanna take money out of circulation, they can decise to sell these securities
- and when they sell the securities, them maybe this guy will buy them
- and those dollars will go back to the central bank and they will go out of commission
- But you have this whole effect over here. If you have more lending occuring and the banks are feeling very confident
- then more of this will happen. You'll get a larger multiplier effect of this lending.
- And if less lending is happening, then you could potentially see all of this contract
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