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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
After one of the previous banking videos, I got a comment: "If everyone puts gold in the banks, what can they used to transact, or to buy food, or to pay for services, et cetera?" And that is an excellent segue into the notion of a bank note. You've probably heard the word before, maybe in some you Charles Dickens novel or something, but we're going to find out in this video it's actually a much more familiar concept than you ever realized, and you probably have some of these bank notes in your wallet as we speak. Let's go back to our example. I have the Bank of Sal. I use 100 gold pieces. That's my equity. Let me draw that. And I use that to build a building. So the 100 gold pieces actually go to the builders and they're from out of town, so they're not going to deposit it back with me. So that's my building. I don't know if you can see that. It's a little picture of a building. And all of the villagers in my city, they come and deposit their gold with me, because my building looks very solid and safe. It's safer than their mattresses, so they then deposit 1,000 gold pieces with me. For the liability side of my balance sheet, I could say 1,000 gold pieces. And on my asset side, I actually get the gold pieces. I should have done that in yellow. So it's actually sitting in my vaults. Now the question was, if all of the villagers put all of their gold into my vaults, what can they use to transact every day? The way I do it right now-- this side is my assets and these are my liabilities, right? I owe them 1,000 gold pieces that they can come and get at any moment. And this could kind of be viewed as a checking deposit. I'll go into that in a second. I'll probably go into that in the next video. But if all of their 1,000 gold pieces are sitting right here on the asset side, or at least in my vault, what can they use to transact? Well, the solution is, I say, hey, instead of taking some of your gold out and using that as essentially money, why don't I give you a note, a note that says you put X amount of gold into my vault. So, for example, for each one gold piece, I will issue a bank note. So let's say I'll say one gold piece bank note outstanding. And then I hand you a slip of paper, and that slip of paper-- and this might start to look a little familiar to you-- says it looks about this shape. It has a nice picture of Sal in the middle, because it's the Bank of Sal, and it is denominated as one gold piece. And now you gave me that gold piece and you get this green piece of paper that only I can print and no one else has the sophistication to do something this fancy. Maybe I use some colors here and I sign it Sal and I do all sorts of stuff that makes it really hard to forge so that no one else can-- I put some holograms on it. Who knows what I do to it, but no one else can forge it. So this is essentially a piece of paper that I hand you that says, you know what? Anyone who holds this piece of paper can go back to the Bank of Sal and get back a gold piece. Then since everyone in the village, they trust that the Bank of Sal will always be willing to exchange one of these slips of paper for a gold piece, instead of using a gold piece to buy something, why don't you just use this slip of paper? And even more, for one gold piece, you don't want to just have a stack of one gold piece pieces of paper around. Maybe if you gave me five gold pieces-- I'll do that in another color-- that rectangle is much larger than it should be relative to 1,000, but I think you get the point-- then I'll have a liability here that says five gold pieces bank note outstanding. I'll call it b-note outstanding. And I'll issue a-- I think you have guessed it. Maybe I'll do it in different colors to show you that these bank notes can come in different colors, but once again, I'll put a famous person there maybe, and I'll make it really hard to forge, and I'll put holograms on it, but it'll be denominated as a five gold-piece bank note. And now, if you were one of the villagers, you gave me your gold pieces, now not only is your gold safe, you have these pieces of paper that are very hard to forge, and that's a key issue there, because if they were easy to forge, then someone maybe completely unaffiliated with this trustworthy bank, completely unaffiliated with Sal, could go out and print these things. So you don't want that to happen. So we're assuming that you can't forge this thing. And now not only is your gold safe, but you have something that you can transact with that's frankly a lot easier than gold. I mean, I could even have a denomination that's-- it could be a 500 gold piece. So if someone gave me 500 gold pieces, I could give a 500 gold-piece bank note out. That'd be my liability, right? Because I know that at some point, someone might give me back that 500 gold-piece bank note, and I'll have to give them 500 pieces of gold, so that's why it's a liability. And maybe that piece of currency is orange. And now this is super useful. Now my bank-- we've done all of the other things, how the bank increases the money supply, and fractional lending, and how the money supply adjusts for the total production and wealth creation in the economy, but now we've found another useful thing that a bank can do, is that besides securing your gold, it's actually providing a unit of exchange that's frankly a lot easier to deal with than gold. I mean, could you imagine lugging around and counting and verifying 500 gold pieces every time you had to spend it? Or everyone would have to have scales, et cetera. Now people can just count there, and as you see, this is money or this is cash. You might be experiencing some form of dissonance in your head because right when I drew that, you were like, wait, Sal, that looks a lot like a dollar bill. And that's true because a dollar bill is a Federal Reserve bank note. It is a bank notes from the U.S. that-- there was a time, and this was a time before central banks and especially if you think about colonial times, you had banks all over the colonies, and they would actually issue their own bank note, so you didn't have one uniform currency. So one bank note might look like that and have Bank of Sal. Another bank note might have Bank of-- I don't know-- Bank of George Bush or something, and people would kind of have to have exchanges between them to realize which banks are good for what. Now we're not as familiar with the term bank note because we only see one type, or at least one type per country. We only see bank notes from one bank, or at least one bank has the right to issue them within the United States and that's the Federal Reserve Bank. And it's not backed by gold. It's actually backed by U.S. Treasuries, and I'll go into that a little later on. Actually, that's a whole fascinating realm of thought. But I just wanted to get this point home, that all you have-- that this bank actually has this other service of issuing these bank notes that are different than the checking deposits, which I will cover in the next video. And then I will use both of those concepts to redo that lending that we did with the irrigation ditches and the factory to show you that the gold actually never even has to leave the bank. The gold just sits in the bank the whole time and the bank can just use its bank notes and checks to actually conduct all of the transactions. See you in the next video.