Overview of fractional reserve banking

what I want to do in this video is give an overview of how money is created in most market-based economies and even a little bit of a discussion of what really is money and we can go into much more depth in future videos and I think in many videos I already have gotten to a much more technical depth in most market-based economies right now there is a central bank which is essentially the the actor they do many things they often will be a regulatory agency as well but their main role is to be to have the right to print money and to put that money into circulation so and I'll rely heavily on the model of the US and that central bank that central bank and that's hard to read the central bank the central bank in some countries is formally part of the government in other countries it's pseudo independent in the u.s. it's more of the pseudo independent flavor of a central bank although obviously closely closely connected with the government the US Federal Reserve a lot of the leaders are pointed appointed by the government it's excess profits go back to the government and so obviously that has very close ties to the government but when the central bank decides to print money it literally can just create it it could literally print physical money or it can create electronic money which has the same exact effect so let's say the central bank it goes out there and it goes out there and it prints it prints three and we'll just focus on the physical right now it's a little bit easier to conceptualize and it just goes out there and it prints three physical dollar bills now it has to figure out how does it get it into circulation how does it get it into the economy and it does not just put it into a helicopter and drop it from that helicopter sometimes in certain circumstances it can lend this directly it can lend this directly to banks certain types of Bank member banks but the typical way that this enter circulation is that the central bank will use this newly created money this newly created reserves I should say to go out into the open market and buy securities and they typically buy very safe securities typically government debt so they will go out there and they will put this into circulation they will put this into circulation and in exchange they are buying they are buying securities from the open market so then these securities from the open market will go to the central bank so these are securities or maybe we could call them bonds and once they do that then whoever had these before whoever was the owner of these securities before they just sold them now they have these dollar bills and they will they could either directly spend those dollar bills or they could deposit those dollar bills in the bank if they spend the dollar bills and whoever they gave those dollar bills to at some point would want to deposit in a bank so some way by buying these buying these securities someone now has these dollar bills and they will deposit them in a private bank so let's draw that so right over here right over here is a private bank and now it has the dollar bills it has these reserves now it has the reserves now that's not the end of the story this money can now be lent and this is key because this is what's what's typical in in most market economies where they have fractional reserve lending so fractional fractional reserve lending which is a bit a bit strange because you are telling the person who just deposited this money right here that you can go at any time and you can take this money out we've got this money for you you can trust us you don't have to be paranoid about what's going on with this money but the reality is is that this Bank is allowed to keep only a fraction of these reserves and lend the rest of it out to lend the rest of it out in order for the system to not be super fragile the central bank then also insures these banks but we'll talk about that into more depth but here I just want to show you how the money is created in this fractional reserve lending system so this Bank right over here says we'll have to keep a little bit of these reserves in case that guy comes the probability of all of my all of them all of my customers coming on the same day and asking for all of their money is low I just have to keep a little bit for whoever does come and then the rest of it I can lend out even though I promised everyone that all of their money is available and so they lend it out to whoever needs to borrow that money who looks like a decent risk and those people might not spend it immediately and so they would deposit it into a bank or they might spend that money immediately they buy a factory or they buy a car or they do something with it and whoever they bought that new thing from those people now have the money and they will deposit into a bank and so this newly lent money will then end up in perhaps another Bank it could even be the same Bank so that will also end up also end up in in a bank right over here and now this Bank it can also only keep a fraction of the reserves and lend out the rest and for simplicity in most banking systems they only have to keep ten on the order of about 10 percent of the reserves in house and the rest they can lend out but over here I'm keeping much larger reserves just for the sake of making it easy to draw this diagram so this Bank right over here maybe it decides to keep this dollar bill and it could lend to this one right over here out and once again when it lends that dollar bill it will end up somehow the person they lend it to might keep it in a bank temporarily or they might immediately buy something and when they buy something it will eventually end up in a bank as a person they bought something from will deposit that money and so it could end up in another bank it could end up in another Bank and now this is interesting and in future videos we'll go into more of the math of exactly how much money is being created and it's an interesting mathematical interesting mathematical problem actually it's a sum of an infinite series and all of that and you can look up look that up if you're interested in those ideas but the basic idea here is even though the central bank printed three units of base money three dollars right over here there's a lot more money in the system you have this guy who made this deposit thinks he has three dollars this person had thinks af2 this person thinks they have one so just in this example over here we have one two three four five six dollars so just right over here we have six dollars in this system six dollars and you might say well is this really money you know this is deposited this guy thinks he has it but he's not using it if he had to use it he would have to withdraw it and then the bank wouldn't be able to do this and this is where checking accounts are really important I'm assuming that these were on demand checking accounts so this guy the reason why he's not going to draw this money is he can still use it as money by writing checks so if this guy let's say this is all the money that he has and he decides that he really needs to buy an apple and that Apple costs $1 and that Apple costs $1 so this is my drawing of an apple right over here he does not have to walk withdraw this dollar out of the bank he can write a check so right now he has claims to the to all three of these dollars he can write a check to the Apple vendor so one dollar one dollar here you know he writes a check gives it to the Apple vendor and now he'll get the Apple so this check is acting as money and now the Apple vendor will have the rights to one of these dollars right over here and now the Apple vendor could write a check so this dollar never has to leave the banking system but because of checks is essentially enabling this check writing it's enabling these tractions transactions to occur so it's still enabling either you can view it as it's it's still acting in some forms of money because the rights to it can change even though it's sitting out in here and it's been lent or you could say that it's enabling the writing of checks that are acting as some form of money and the whole reason I want to do this I'm going through this exercise to show you that the amount of money in circulation isn't really in the central banks or not directly into central banks control they can definitely decide hey I'm going to print money buy securities put it into circulation or if they want to take money out of circulation they can decide to sell these securities and then when they sell the securities maybe this guy will buy them those dollars will go back to the central bank and maybe they could put it out of commission but you have this whole effect right over here if you have more lending occurring if the banks are feeling very confident then more of this will happen you will get more of this the multiplier effect of this lending and if less lending is happening then you could potentially see all of this contract