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

Banking 4: Multiplier effect and the money supply

How "money" is created in a fractional reserve banking system. M0 and M1 definitions of the money suppy. The multiplier effect. Created by Sal Khan.

Video transcript

Let's think a little bit about what happened in the last video. I'll review again these different notions of money supply. And then let's talk about whether it's fair for people to think that they really have the money that they have. So in the original video, after the crop was harvested, the farmers deposited 1,000 gold pieces in my bank. Then I lent out 900 of those. I had to keep some reserves in case those farmers wanted some of their money back. And I figured they would never need more than 10% at a time. I lend it out. Someone has a great idea to build an irrigation canal, so that more fields become usable and get access to water. To build that irritation canal, they take those 900 gold pieces, and they pay a bunch of workers. Those workers now have the gold pieces. They need someplace safe to put it. They put it back in my bank. Now I get 900 gold pieces of deposits. I put 10% aside again. And now I lend out 810 gold pieces. Let's say I lend it out for an entrepreneur who wants to build a factory to build some type of tools that might make the apple harvest more efficient, or faster, or need less labor, or whatever. That entrepreneur takes those 810 gold pieces and pays the builder in the town. And then the builder now has 810 gold pieces, and then he gives the money back to me in my bank. Because I'm the safest place to keep it. I stop the chain there. You can keep going on and on. Although there is some end. Notice that these values get smaller and smaller every time. And we'll do a little bit of math on that to figure out how far it can go. But then I take the builder's money, and I said, well, you know, this banking idea's a new idea to me. I'm just going to leave it all as reserves. I want to see how it all plays out first. So then we said, how much money is in the system? And it all depends on how you define money. And we made one definition of money called m0. In m0 we said-- we'll call this our narrowest definition. And this is literally, how much gold is there in the system. Or how much stuff is there in the system that could be immediately used for conducting a transaction. And I'm assuming, for the sake of this argument, that none of these players actually kept any gold in their pockets, or kept some cash in their wallets for a rainy day. Although if they did, we would included it in this calculation. I assume that everyone always deposits their gold with Bank of Sal. So when we did that calculation there was this 100 gold pieces of reserve that we had set aside at first. Then 900 here. And then 810 here. And if you add those up, you get 1,000 gold pieces in the system. Which makes a lot of sense, because we originally had 1,000 gold pieces in the system. In the example, at least as I described it, we didn't have anyone discovering any new gold. Nor was any a gold eaten or destroyed in some way. So it makes sense that there are 1,000 gold pieces. But then there's a more interesting question. If you went around the city and you asked everyone how much money they had, they'll say, I have this much in my checking account with the Bank of Sal. If you ask me how much money I had, I would tell you how much is in my checking account. I actually have very little cash in my wallet right now, if any of you are thinking of mugging me. All of my money is in a checking account. So if someone asked me how much money do you have, I'd give that number. So if you went around the town, and you asked everyone, how much money do you have, and you added it up, you would get the total of the of their checking accounts. And so we had 810 gold pieces from the contractors, 900 gold pieces from the ditch diggers, and then 1,000 gold pieces from the farmers. Let's see, 1,900 plus 810. You get 2,710 gold pieces collectively in checking accounts. And since I'm the only bank, that's the total of my liabilities here. And we call that m1. And I'm calling these that for a reason because these are the actual words that are used by economists and our government officials. There's a couple of really interesting questions here. One is how did a 1,000 gold pieces get turned into 2,710. And then, this 2,710, does it represent real wealth, or was this some kind of weird shell game we played, and it represents some type of weird pyramid scheme? How it got created-- we went through the mechanics, right? Every time I set a little aside, I lent some out, and then they deposited, et cetera. That's how it got created. The interesting question is, does it represent real wealth? The answer is it represents real wealth if each of these investments were real investments. So if this 900 gold pieces that were used to build this irrigation ditch or whatever it is, if that project actually does generate at least 900 gold pieces of future wealth-- essentially you could at least pay back the 900 gold pieces. It'll probably generate more if it's a good project. But if it generates at least 900 gold pieces of future wealth, then this is a real asset, right? This is a real asset. Likewise, if this factory really does generate at least 810 gold pieces of future wealth, if it really will allow us produce that much more apples or gold or whatever, this is a real asset here. So these people, this wealth, really does exist. This 2,710 gold pieces of, quote unquote wealth, really does exist as long as the projects that were the justification for borrowing the money actually do generate future wealth. So there's a couple of things to realize. There are not 2,710 gold pieces in this world. There only 1,000 physical gold pieces. But if these projects are real projects that are actually not mismanaged, they're not just some type of pouring money into a hole type of project, then we do have 2,710 gold pieces worth of wealth. And I really want to stress this point. Remember gold isn't wealth in of itself. Gold is used to represent wealth. You cannot eat gold. You cannot live under gold. Gold will not transport you someplace. Gold will not improve your health. It's something that's used to represent wealth. Sometimes people think it is wealth itself, and that's actually a misconception. So this 2,710 perceived gold pieces, that does represent real wealth, although it doesn't represent real gold pieces. And once again you might say, oh boy, this is some type of a shell game. But it's really not. As long as these investments are good investments. Remember, these are wealth generating investments. And notice, the money supply-- at least as we defined it with this m1-- it expanded to facilitate real economic production. So as long as this factory does generate wealth, or this irrigation ditch does generate wealth, then the money supply did not grow faster than the amount of wealth out there. If before a gold piece bought an apple, now hopefully a gold piece will still buy an apple. In fact, and this is an important thing to realize, if these investments are very good, you're actually going to have-- let's say that we used to produce 1,000 apples per year. Notice apples are real wealth. Apples are something that you can consume. They will keep you living. And you can also view them as a form of investment, because by eating them you're able to do work. But anyway, let's say before all of this investment started happening, our economy could produce 1,000 apples. Now let's say that after this irrigation ditch was produced, we go from being able to produce 1,000 apples to being able to produce 2,000 apples a year. And once again, a lot of wealth was created. Remember, we only took 900 gold pieces to build this. And all of a sudden we're doubling. We're able to produce another incremental 1,000 apples a year. Which, in our old economy, was worth 1,000 gold pieces. So that actually will definitely pay off. You borrowed 900 gold pieces and this project will generate, not 1,000 gold pieces in total, it'll actually generate the equivalent of 1,000 gold pieces per year. It increases our production of 1,000 apples per year. And likewise, let's say that this takes us from 2,000 apples a year to 3,000. So let's think about it. Now in a a given year, how many apples are being produced? We used to only have 1,000 apples being produced. Now we have 3,000 apples being produced, because these were really good investments. They really improved our productivity. So now, if you say everyone in the economy thinks that they have 2,710 gold pieces, or some equivalent of them, and we can produce 3,000 apples, now the money supply, 2,710, actually grew slower than our wealth. Let me let me draw that out. Let's say money. Wealth. I think it's really important to separate the two concepts. Money is used to transact wealth or represent wealth. It is not wealth in and of itself. And that has some important philosophical underpinnings to it. It'll probably make you live happier if you realize this difference. But before we had 1,000 gold pieces, before the banking and this fractional reserve system existed. And we had 1,000 apples of wealth per year. And I'll go more into the velocity of money. But after all this stuff happened later, we had 2,710 perceived gold pieces. This was our m1 definition. Our m0, the actual physical gold, was still 1,000. But how many apple do we produce a year? We now produce 3,000 apples. So notice, the ratio of gold to apples has actually improved. And now, if you think about it, an apple is actually going to cost less gold. Before roughly you had one gold piece per apple. Now you have less than one gold piece per apple. So because of our innovation, we actually experienced deflation. So you might have said, all of this money was created out of nowhere. This money doesn't exist. This will lead to inflation. But no, this is a very important point, because the money was put to work in actual productive investments that create wealth, that make the pie bigger, or the pie of apples bigger, we actually experience deflation. And our economy actually grew. And this was actually a very very positive example. I'll see you in the next video.