Banking 3: Fractional reserve banking

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 let's see make it my pen tool right I said you know 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 on on our island and so they and then every year they just have this you know collectively they have I'll just make up a number a thousand gold pieces that they get or at least this year I'll call it a thousand gold right they have a thousand gold coins that they get at the end of the year normally the farmers just kind of stash it under their mattresses or or kind of dig up a hole and put it there and I said well you know what a waste because there are actually good projects out there that people could maybe irrigation ditches factories whatever else 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 that I'll do it all over again just like I did last time let's say that I have I don't know I personally had 100 gold pieces and I'm going to stick with gold because I wanted to show you how the money creation there is this multiplier effect even when you're using gold some people think it only happens with paper money this is all a byproduct of the fact fractional reserve system which was essentially what I showed you in the last two videos but let's just go through the whole example so I take 100 gold pieces and I construct this nice vault looking building right so this is real estate or building and it's worth one hundred one hundred 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 I was like one your money's not safe there and 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 thousand gold pieces into so now I have this liability that I have a thousand gold pieces liability and why is it a liability because I owe it to the farmers they 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 we're going to want to pay attention to them later let's say I put 10% aside so I put a hundred 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 I'd actually need my money I need to you know my my 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 so this 900 gold pieces I lend out let me do that in a different color I'll do it in green nine hundred gold pieces I lend out so it's an asset but the gold is gone I take that gold this 900 gold remember I had a thousand gold pieces come in I kept a hundred of it and now I'm going to lend it to someone who has a really good project so say let 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 is usable to make more apples the next year 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 right so I give my 900 gold pieces to them to build the essentially dig these ditches well that 900 gold pieces that then goes to the workers right 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 right well these workers that they're just like the farmers they say well you know I don't want to put it in my bed and I want to get interest on it and 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 and I say great so what I do is I take their nine hundred gold pieces and I take it as a deposit so let me try to draw that as a deposit so I take their nine I'm going to try and see if this is a thousand nine hundred might be about that nine hundred gold pieces so this is this is the farmers deposits right that was kind of the initial money so then I get the 900 gold pieces from the workers I want to make this as neat as possible but I didn't want to go through the pain of having multiple banks because you could 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 so these 900 gold pieces are essentially deposited back into my bank for safekeeping and I say boy you know I don't need to keep all of this 900 all of this 900 gold pieces here I could lend it out again for some useful project so once again I say well you know 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 percent of them will come in at a given day so let me set aside ten percent of that so I'll once again I'll have ten percent reserves so I'll set aside ninety gold pieces set aside ninety gold pieces and then the other let me do that in the lending color the other the other 810 gold pieces I lend out and let's say I lend it out to some entrepreneur and remember I'm getting interest in 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 build factory build factory 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 you know factory contractors the people who factory contractors the people who build the factory contractors well once again now they have 810 gold pieces and they're like well 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 so they take those 810 gold pieces and deposit it in my bank and then I could continue well let's just say that I could I could just continue this process so forth zone and just so you know it doesn't it doesn't go infinitely right because every step of the way we're having a little bit less and you can I'll do the little I'll do the fancier math on how to figure out how many steps we can do but let's just make let's just stop it there just for the sake of brevity and just so I don't run out of space on this so they take 810 gold pieces and I kind of 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 put I just keep all of those 810 gold pieces as reserves so this is my balance sheet after you know maybe if these 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 equity this is liabilities right these are deposits that people that I owe to people deposits equal liabilities from a bank point of view they're assets for those people and liabilities and then these are my assets some of them are cash money right in Magette these this 810 this 90 this 100 this is 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 well at least this and this these are loans that I lent out to somebody and that's an 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 so it all depends how you define money so let's make a definition let's say I define I make a definition called m0 and this is just how much gold is there right how much gold in the system well we can go and count it right well 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 if your 810 plus 90 plus 100 is equal to a thousand gold so there's a thousand gold pieces and that makes sense right because we had a thousand gold pieces to begin with and we didn't mind for any new gold or we didn't turn any I don't know lobe you we didn't use any lodestones to turn lead into gold or anything like that we we just had the original thousand gold pieces and there's no way to create more they don't reproduce on their own so we still have a thousand gold pieces and we can kind of view that as our narrowest the definition of the money supply now let's say another definition let's call this m1 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 in terms of their checking accounts well the farmers think that they have a thousand gold pieces the original ditch construction workers think they have 900 and then the factory builders think they have 810 right so if you add them as one thousand plus nine hundred plus eight hundred and ten let's see that's nineteen hundred that was at 27 ten twenty seven ten gold pieces so if you asked if you went and surveyed everyone in the city and you said how much do you keep in your checking accounts or how much do you have on demand deposits in a bank if you added up all of those numbers you would have two hundred and ten to two thousand seven hundred and ten gold pieces if I added my numbers correctly this is the multiplier effect and this happens whenever you have a fractional reserve system and this is what people say when 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 a thousand gold coins but because of this multiplier effect people think that there are two thousand seven hundred and ten gold pieces in the next video I'll address the issue of whether they are correct to think this see you soon