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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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Video transcript
Let's review a little bit of what we've learned about reserve banking and then we'll extend this to the notion of an elastic money supplier, a money supplier that can grow or contract as people need money-- or hopefully grows and contracts as people need money. So let me create a a couple of normal commercial banks. Maybe I'll call these national banks. They have a national charter. So let's see. I have some equity and part of that equity-- most of it is some gold that I initially capitalized the bank with. And then some of it is a building. Trying to draw this as neat as possible, but I think you understand my situation. Then I take some gold deposits from whoever-- the farmers after the crop has been harvested. And then offsetting that, I have all of the farmers' deposits. I'll do that in a blue color. So that's one farmer's deposit. That's another-- maybe there's only two farmers. And then we learned in fractional reserve banking that I can leverage up this amount of capital I have. There's a certain ratio between the amount of capital-- in this case, gold or reserves I have-- and the amount of demand deposits I can have. So let's say my reserve requirement in this world is-- just because I don't want this bank to become too tall-- let's say it's 50%. We know in reality reserve requirements are more like 10%. Let me write that down. So that means that my ratio of gold to demand deposit accounts cannot be any less than 50%. So whatever this amount is, I can double it in terms of demand deposit accounts and the way I do that-- let's say this is collectively 100 so I could have up to 100. Let's say this right here, this is 50. So I can have up to 200 in demand deposit accounts. So I can essentially lend out money and create demand deposit accounts. This is all review for you, hopefully. So I could lend out 150. Those are my liabilities and then these are my loans and my-- so that's one loan I make out and I just create someone's checking account. That's the loan asset and I create a demand deposit account for them. That's the liability. This here could be a big loan, et cetera. And then I'm not the only bank in this universe. My other bank in the universe. I just want to show you that there are multiple banks. Then we said there are a couple of issues with this. You have a 50% reserve requirement, which is very high, but what if there is a situation where for whatever reason your reserves temporarily drop below that 50%? How do you get that extra gold? You don't want to go to people and say, can I have a little bit more gold? Then they're going to get scared and all pull out of your system, but if you're a little bit below 50%, but if the other bank is a little bit above 50%, it'd be a convenient way if you could borrow from that other bank-- or even better, if there was a central depository where all of these gold reserves were, then you could just borrow directly from that central depository if there were no other bank to borrow from. So you could kind of view it as a lender of last resort and we'll go into more of the technicalities of that one, in particular talk about our current system. With that said, we created a reserve bank where we put these deposits. Let's see. There's 200 of deposits in this world. Let see me if I can just copy and paste that. So that's one of the reserves and then they're the same, so then that's the other reserve. It doesn't look that neat. All the banks got together and created this. It's a private bank, but we'll go into more details of of how the actual Federal Reserve works. So those are the actual gold reserves. Those are the assets of that bank. Actually, I should move it over some. OK. And then the liabilities for this central reserve bank, these are the demand deposit accounts for these nationally chartered banks. So he took all of his gold, put it here, and so now he has-- to simplify it, he has a demand deposit account, but I'll assume that he just got reserve notes to show that he had access to this gold. So let's say that this is 100 notes outstanding. This part corresponding to 100 gold pieces-- and this is another 100-- although notes outstanding, it's fungible, you could mix them up because you don't know where they came from or whatever. That's what's different about those relative to a checking account. And so essentially this guy gives his gold here and in exchange he gets these Federal Reserve notes, which are like green pieces of paper. And now these are actually his reserves. His reserves are no longer gold. His reserves are how much of these Federal Reserve notes he has? And we learned in the last video that only the Federal Reserve-- or the reserve bank-- I haven't called it the Federal Reserve yet, but I think you see where this is going-- only they can issue these notes. And these notes are these rectangular green pieces of paper with faces of presidents on them, et cetera, et cetera. And let's say in the government we live in, they kind of sanction-- even though this is officially a private bank, this reserve bank, it's set up in such a way that even though all of the original banks might have originally capitalized it with some equity, they really don't get any of the profits of this bank-- and I'll go into detail on how the actual Federal Reserve works. But let's just say any surplus profits of this bank actually just go back to the Federal government. So the Federal government doesn't-- these banks don't make any money off of this-- and actually let's say that the board of directors of this bank is actually appointed by the government, et cetera, et cetera. So it's key to the financial system. So the government says, these notes, sure, it's issued by this reserve bank, but we want people to have a lot of faith in this currency because this is the currency that we use in our world, in our nation, so in order for people to have unlimited faith in this currency, we are going to make it an obligation of the government-- so it's issued by the bank. Let me write that down. This used to confuse me to no end. Issued by the reserve bank, but it's an obligation of the government. Now, what does that mean? Well, that means that if for whatever reason-- even if this reserve bank were to somehow not have the gold to back it up, it would go bankrupt, but even in that situation, the government would still be obligated to give you the gold equivalent of these notes, whatever we decide it is. Maybe it's 35 of these dollars per ounce of gold or whatever. But that's what that means. So that gives a lot of people confidence that these things are, you can almost say, as good as gold. Why does it matter that the government-- how can you trust the government? Well, the government can just tax people, whether they're going to tax them in terms of dollars, whether they can tax them in terms of gold, whether they can tax them in terms of goods and services. So as long as you think that that economy-- whatever the economy is that this government is governing over-- as long as you think that that economy can somehow support the gold to back this up, you should say, this is as good as gold-- or at least support the goods and services. Well, that said, let's introduce the notion of an elastic currency. Actually before I do that, let's go back to one thing this government does. So we said it's an obligation of the government, right? Which means if all else fails, the government is going to give you the value behind these notes. I'll introduce you to another concept, which is actually very similar to these notes-- and that is a government debt or government borrowing. Let me draw that down here. I think I'm going to run out of time, but I'll continue it in the next video. So I'm the government, right? I mean, you could almost view the government's asset as its ability to tax people, but if I'm the government and I issue these government IOUs-- and we'll call them treasury bonds and bills-- let's call them treasuries, generally. Treasury bills are short term treasuries where the government borrows for a shorter amount of time. Bonds are longer term. I think I've gone over that in the yield curve video, but I'll do that in more detail. But they're just IOUs from the government. Now, these are going to be considered as risk free. Why are they considered risk free? Because they are denominated in the same currency that the government, that the economy that this government governs over, operates in. So if this government-- and I think you can understand that this is essentially the U.S. government-- if it borrows money from you-- so it gives you an IOU. So this is me. Let's say this is me, this is the government. If it gives me this IOU and I give it $100, why do I know that this IOU is risk free? Well, because unless he starts-- the government-- I'm making him masculine-- but unless they start issuing an unusual number of IOUs and just have so much interest that they can't sustain, you know that they can always tax more people to get you back your $100. So you view this thing right here as risk free. So whenever the government goes out there and says, hey everyone, we have a new war we want to fight or some new type of scheme, new bureaucracy we would like to create, we are going to borrow money from you-- someone is going to give them their currency, their Federal Reserve notes-- and in exchange, the government's going to give them these risk free IOUs. And then the government can use these reserve notes to go buy goods and services or pay soldiers or pay the bureaucrats. Now we're going to use that idea in the next video to learn how this Federal Reserve bank or this reserve bank can buy and sell these government securities in order to change the money supply. See you in the next video.