If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
Current time:0:00Total duration:11:28

Video transcript

everything we've covered so far dealt in a world of only one bank and we all know that there are more than one banks in this world so let's see what happens in that example so I've drawn the balance sheets for three hypothetical banks in a world where gold is the reserve currency and let's see what happens in that world so let me just show you all of the so that's the first one and that's the last one they'd all didn't fit on the screen but just so you understand and a bit of a review of what we covered in the last several videos in these balance sheets of course the left side are the assets the right hand side up until here and the liabilities so from here to here that's liabilities and what's left over is the equity so in every and every balance sheet just to be consistent I made this blue color is equal to the equity let me write that down equity the blue color is the equity in every one of these banks and just to be consistent I made this little orange color the building Brown for building and this yellow or this gold color that's actually the role gold reserves of that bank and each of these lines these divide the various other assets of the bank in this case they're just loans maybe two different entrepreneurs and then these green lines separate the different demand deposits or checking accounts that are on with that bank and then the green this filled in green for example in this in this middle bank that shows its notes outstanding remember there's two ways that you can essentially give someone kind of a an IOU from this Bank one is to say oh you have a checking account and you can write checks against it the other way is to issue this bank note and someone can come back later with this bank note and you should have to give them an equivalent amount of gold so in this middle Bank this green area that shows its bank notes outstanding this purple area in this Bank that's its bank notes outstanding and then down here this off-white color is its bank notes outstanding fair enough we've we've created a world with three banks now what is the problem here or or are there any problems well they're there there are a couple that that I see immediately the first is all of them might have different reserve ratios but I'm I've in the last video I kind of talked about a world with regulation but let's say in this reg in this world since every bank is kind of a separate entrepreneur maybe it was originally the Goldsmith's they all just made their own rule of thumb that if I have this amount of demand deposits based on how my customers act or whatever or based on my liabilities or however it works I'm gonna keep this amount of gold so maybe this guy's reserve ratio this guy's reserve ratio here I don't know what the ratio of this this is but maybe his reserve ratio is 8% so for every hundred gold pieces of demand deposits and bank notes he keeps eight gold pieces on reserve maybe this guy is ten percent looks a little bit better maybe this guy up here is keeping a twelve percent reserve ratio so there's no consistent reserve ratio so let me write that down reserve ratio reserve ratios inconsistent ratios not equal and and there's a couple things that that might lead to maybe this guy right here he was the first bank to start or maybe this guy this kind of 12% reserve ratio and people really trusted it for a long time every time they deposited money and then they came back later they were able to find it he really lent money really well so that there was never any scare on this bank no one ever felt afraid to keep their deposit there but as the banking business got more and more profitable more and more risky people showing it showed up and this guy only has an 8% reserve ratio and maybe one day 9% of their checking accounts want their money back and this guy is not good for this guy up here the 12% guy he knew that 9% could happen they don't on any given day nine percent of your demand deposits might want the gold back so that's why he kept at 12% but this guy kept an 8% so he could get an extra interest on more loans so one day he can't give his gold back and that scares everyone so everyone comes and you have a run on this bank but he's not the only bank everyone starts having less trust in the banking system as a whole and so their runs on all of these banks and that that's unfortunate for two reasons one these guys were safe to begin with they kept enough reserve ratio so that people could get their gold and then the other sad thing about it is if this guy you know just needed another 1% I keep going off the video screen if this guy just needed another 1% of gold he could have borrowed it from that top guy and then you would have prevented this whole banking crisis he could have borrowed it from either this guy or that guy right if this guy's goal gets depleted and more people still want money this guy would clearly rather borrow it to lend the money to this guy as long as he still solvent that have a you know a systemic run on all banks so bank 1 run better let me write that down so bank runs bank runs affect everyone so in this world that we're dealing with right now just one weak link in the chain can break the whole chain if you just have one irresponsible bank it'll create a bank run on all of them even though some of the more some of the more capital rich banks could have lent to the other ones and then finally and I did this year this is a situation that we're not familiar with today but it's a it's a situation that's happened many times in history it happened in in the colonies before we had our independence is that you had a bunch of different banks each issuing their own bank notes as a form of currency so this one up here issues the purple bill this Bank here issues a green bill and this Bank here issues this off white bill besides the confusion you're always going to have all of these exchange rate differences except you don't know you don't know ahead of time you know this guy is the riskiest bank so maybe his bills should be worth a little bit less than this guy up here but you don't have you it really just becomes a big mess to the economy for someone then you know in a cash register to keep track of in this case I only have three banks would imagine if all 13 colonies each had their own banks that were each issuing their bank notes and you always have to translate between them and then one bank default and their notes are worth their bank notes are worth nothing and you have to worry about that so you have another problem inconsistent currency inconsistent paper currency inconsistent currency and I think you know where I'm going with this so what's the solution to all of this well what if there are a way one and I guess you could do this without any you know extra institutions you could just regulate reserve ratio so that's easy to do that's just government intervention to say if you want to be a bank in our world you have to keep at least 10% reserve ratios but we have to think about who regulates that and who sets that reserve ratio but it's fair enough that we need someone to regulate it we don't need a separate institution but how could we do this mechanism where we can prevent bank runs especially when there's money to lend from one bank to the other and if we could use a mechanism that prevents this and provides a consistent currency then we're all set well the only way you can provide a consistent currencies if you only had one bank issuing currency so let's call that Bank a reserve bank let me draw its balance sheet maybe I should just copy and paste one of these you see what happens there you go so let's say I had I these three banks get together are all the banks in this world to get together and say hey let's start a new institution where we all keep our gold reserves there so what happens is is this guy this guy this guy they all keep their gold reserves at this central bank so let's see them you have to put more gold reserves in this central bank so let me draw it out so this guy's gold reserves then that this middle guy is gold reserves and then his third guys gold reserves all go there and now with these guys instead of having gold reserves here what do they have they have checking accounts they have checking accounts with the Reserve Bank let me write that down so now these are these all become checking accounts with the Reserve Bank I'll try to draw it right beside the gold although it doesn't have to be so that's a checking account with the reserve bank that's a checking account with the reserve bank and that's a checking account the reserve bank and let me erase the top of that balance sheet just because I don't want it to get make things confusing so that's the balance sheet that our Reserve Bank now has now what does this do well it definitely solves that that bank run problem because now in this world and of course we're regulating now and I kind of threw that out there because this guy will be the regulator this central bank will be the regulator but what you can say now is if for some reason let's say 11 percent of these demand deposits come to 11 percent of these people want their money all of a sudden this guy he just has to go to his reserve bank account and he can borrow from one of the other players the gold is all essentially in one place now the notes issue how do we how do we solve that well what if by you know government law from now on only one bank can issue banknotes and that's the central bank so maybe this let's say this middle guy instead of having just a checking account maybe he took half of it as a checking account and half of his gold deposits he gets in these bank notes of this Reserve Bank so 1/2 so now this these turn into bank notes of the Reserve Bank and these bank notes of the Reserve Bank are the only currency that's allowable so we've already solved two problems we've called we solved an inconsistent currency and now now to think about what starts to happen the reserves of these banks no longer become they no longer become gold the reserves at the banks that people actually interact with now become these banknotes the banknotes of this central Reserve Bank right and this gold is just sitting in some you know big vault someplace in this world right now so let's just let's just I know it's a little bit disjointed so reserve ratios now you have a central bank central banking authority where they all chipped in a little bit of money created this big vault and this central bank dictates reserve ratios it prevents bank runs because if for whatever reason let's say on someday all of this bank's customers get scared and want their gold back this bank can just go to its checking account and borrow gold from the other banks and it'll get transferred to it but if you think about it in a world where people get used to enough of this one of this one central bank note then people probably won't and want that gold back they'll probably start viewing this one currency as the equivalent of gold so when people actually want their money back they don't even have to give gold they can just give banknotes but there's this one consistent banknote now from this central Reserve Bank anyway I think I said the word central and reserve too much but I will see you in the next video hopefully it wasn't too complicated and I think you see where this is going we'll slowly extend this to getting off the gold standard and how this relates to the the Federal Reserve or central banks as we know them today see you soon