Let's return to our fairly
simple banking example, and see if we can use it to actually
understand, or at least get a better idea,
of what money is and how it's created. So in the original example,
I said, I have this idea. I have all of these farmers who,
at the end of the season, they sell all of their apples--
let's say that's the main cash crop on our island. And then every year they just
have this-- collectively they have-- I'll just make up a
number-- 1,000 gold pieces that they get. Or at least this year, I'll
call it 1,000 gold. They have 1,000 gold coins
that they get at the end of the year. Normally the farmers just kind
of stash it under their mattresses, or dig up a
hole and put it there. And I said, boy, what a waste,
because there are actually good projects out there that
people could-- maybe irrigation ditches, factories, a
tool factory, anything else. But there's just no money
for those people to build those things. If only somehow I could take
this money and use it for those projects, then we would
actually create wealth. We'd have innovation. And our entire pie
would get bigger. So what I do is, I start
up this bank. And I'll do it all over again,
just like I did last time. Let's say that I personally
had 100 gold pieces. I'm going to stick with gold,
because I want to show you how the money creation-- there is a
small multiplier effect even when you're using gold. Some people think it only
happens with paper money. This is all a byproduct of the
fractional reserve system, which was essentially
what I showed you in the last two videos. Let's just go through
the whole example. So I take 100 gold pieces, and
I construct this nice vault looking building. So this is real estate,
or building. And it's worth 100 gold. These are my assets. Assets on the left-hand
side, liabilities on the right-hand side. And then I go tell all of
these farmers, one, your money's not safe there. If you actually keep it as a
deposit in my nice looking building, I will give
you interest on it. So those farmers say,
great idea. So they all deposit
their 1,000 gold pieces into my bank. So now I have this liability. I have 1,000 gold pieces
liability. And why is it a liability? Because I owe it
to the farmers. At some point in the future,
they're going to come back to me and say, hey, you know
that gold I gave you, I want it back. So it's a liability to me. But it's also an asset
on my side, right? But my whole business
model is, I wanted to put this to work. So what I do is, I
put some aside. So essentially, I make
some reserves. I'll do the reserves in red,
because we're going to want to pay attention to them later. Let's say I put 10% aside. So I put 100 gold
pieces aside. And I do that in case any of
those farmers, the next day or the next week, come to me and
say, oh, you know what, I actually need my money. My son needs a haircut, or
whatever the need might be. But anyway, I put 100 gold
pieces aside as reserves. And then the remainder-- this
900 gold pieces-- I lend out. Let me do that in a
different color. I'll do it in green. 900 gold pieces I lend out. So it's an asset. But the gold is gone. I take that gold-- remember, I
had 1,000 gold pieces come in-- I kept 100 of it. And now I'm going to lend it
to someone who has a really good project. Normally, you would lend it
to a bunch of people. But for the sake of simplicity,
let's say I lend it to someone who has an
irrigation project. He's going to take that 900 gold
pieces and pay a bunch of people, who are probably not
doing anything anymore because the apple crop has been
harvested and sold, and they're going to build an
irrigation canal so that more land is usable to make more
apples the next year. soon. And I say that's a great
investment because they're going to make more apples, or
they're going to sell the water to the farmers. And they should be able to
pay some interest to me. So I give my 900 gold pieces
to them to essentially dig these ditches. Well, the 900 gold pieces, that
then goes to the workers. The borrower borrowed
them, and then paid it to the workers. 900 gold goes to the workers. And so after the project is
done, you have a bunch of workers with 900 gold pieces. Well, these workers, they're
just like the farmers. They say, well, I don't want
to put it in my bed. And I want to get
interest on it. It's not safe inside my house. So, let's say that my bank
is the only game in town. So they go back to my bank. And they say, hey, Bank of
Sal, I want to deposit my money with you. I say, great. So what I do is, I take their
900 gold pieces, and I take it as a deposit. Let me try to draw that
as a deposit. If this is 1,000, 900
might be about that. So this is the farmers'
deposits. That was the initial money. So then I get the 900 gold
pieces from the workers. I want to make this as
neat as possible. I didn't want to go through the
pain of having multiple banks because you could do
this with just one bank. Maybe in a future video, I'll
do it with multiple banks, just to show you that all
the deposits don't have to go to one place. But it's the same idea. Anyway, these 900 gold pieces
are essentially deposited back into my bank for safekeeping. And I say, boy, I don't need to
keep all of this 900 gold pieces here. I could lend it out again
for some useful project. So once again, I say, well,
these are demand deposits, which means that these farmers
could demand them at any time. So let me put a little
bit aside. I know statistically that no
more than maybe 10% of them will come to the given days. So let me set aside
10% of that. So I'll once again have
10% reserves. So I'll set aside
90 gold pieces. And then the other-- let me do
that in the lending color-- the other 810 gold pieces
I lend out. And let's say I lend it out
to some entrepreneur. Remember, I'm getting interest
on all of this. But we're not concerned with the
interest right now, we're concerned with the
money supply. So I lend it out to some guy who
wants to build a factory, build a factory for
cutting tools. That'll help all of us become
more productive when we have to harvest our apples, or maybe even digging the ditches. So once again, this 810 gold
pieces, they're going to go to the construction workers
or the contractors who built the factory. So let's call it factory
contractors, the people who build the factory. Once again, now they have
810 gold pieces. And they're like, I don't like
keeping it in my house. There's that nice fancy vault
that Sal has, and he gives interest on it. So they take those 810
gold pieces, and they deposit it in my bank. And then, let's just say that
I could just continue this process, so forth and so on. And just so you know, it
doesn't go infinitely. Because every step of the
way, we're having a little bit less. I'll do the fancier math on
how to figure out how many steps we can do. Let's just stop it there, just
for the sake of brevity, and just so I you don't run
out of space on this. So they take 810 gold pieces,
and I for the most part feel that I've lent enough
money out there. So I keep all of this 810
gold pieces as reserves. So I don't lend that out,
although I could. I could just set aside 10% of
it, 81 gold pieces, and then lend the rest of it out. But I don't do that. I just keep all of those 810
gold pieces as reserve. So this is my balance sheet. Maybe if these transactions
occur all at once, over the course of the year, this is what
the Bank of Sal's balance sheet looks like. These are my assets, and these
are my liabilities. And notice, assets are
still equal to liabilities plus equity. This was equity. This is liabilities. These are deposits that
I owe to people. Deposits equal liabilities from
a bank's point of view. They're assets for
those people. And then these are my assets. Some of them are cash
money, in magenta. This 810, this 90, this 100,
these are gold coins that are sitting in my vault, so that's
definitely an asset that I have. And then these are loans
that I lent-- at least, this and this-- these are loans that
I lent out to somebody. And that's as asset, as long
as they pay me back. So now, we have set it all up. My question to you is, how much
money is there in the system or in our economy? It all depends how
you define money. So let's make a definition. Let's say I make a definition
called m0. And this is just, how
much gold is there? How much gold in the system? Well, we can go and count it. Remember, notice, all of the
gold is being held in my bank. So we just have to go to this
one bank and count how much gold it has. It has 100 gold here, 90 gold
here, 810 gold here. So 810 plus 90 plus 100 is
equal to 1,000 gold. So there's 1,000 gold pieces. And that makes sense, right,
because we had 1,000 gold pieces to begin with. And we didn't mine for any new
gold, or we didn't use any lodestones to turn lead into
gold, or anything like that. We just had the original
1,000 gold pieces. And there's no way
to create more. They don't reproduce
on their own. So we still have 1,000
gold pieces. And we can view that as our
narrowest definition of the money supply. Let's say another definition. Let's call this m1. And I'm running out of time. And that is, how much money do
people think they have, in terms of their checking
accounts? Well, the farmers think that
they have 1,000 gold pieces. The original ditch construction
workers think they have 900. And then the factory builders
think they have 810. So if you add them, it's 1,000
plus 900 plus 810. Let's see, that's 1,900-- that's
2,710 gold pieces. So if you went and surveyed
everyone in the city and you said, how much do you keep in
your checking accounts? Or how much you have on demand
deposits in a bank? If you added up all of those
numbers, you would have 2,710 gold pieces, if I added
my numbers correctly. This is the multiplier effect. This happens whenever you have
a fractional reserve system. And this is what people
say when they talk about the money supply. It depends how you measured--
and this is what people talk about when they talk about
money being created. We had 1,000 gold coins, but
because of this multiplier effect, people think that there
are 2,710 gold pieces. In the next video, I'll address
the issue of whether they are correct
to think this. See