Banking and the expansion of the money supply
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 gone into a much more technical depth. In most market based economies right now there is a central bank, which is essentially the actor, they do many things. They often will be a regulatory agency as well. But their main role is to have the right to print money, and to put that money into circulation. And I'll rely heavily on the model of the US. That's hard to read. The central bank in some countries is formerly part of the government. In other countries, it's pseudo-independent. In the US. It's more of the pseudo-independent flavor of a central bank, although obviously closely connected with the government. The US Federal Reserve, a lot of the leaders are appointed by the government. It's excess profits go back to the government. And so obviously it 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 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 to this directly to banks, certain types of banks, member banks. But the typical way that this enters 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. And in exchange 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 the securities before, they just sold them. Now they have these dollar bills. And they could either directly spend those dollar bills or they could deposit those dollar bills in a bank. If they spend the dollar bills, then whoever they gave those dollar bills to at some point would want to deposit it in a bank. Some way, by 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 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 typical in most market economies where they have fractional reserve lending. So fractional reserve lending, which is 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 that this bank is allowed to keep only a fraction of these reserves, and lend to the rest of it out. In order for this 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, well I have to keep a little bit of these reserves in case that guy comes. The probability of all 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 by a factor, or they buy a car. They do something with it. And whoever they bought that new thing from, those people now have the money and they will deposit it 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 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 on the order of about 10% of the reserves in house, and the rest they could 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 this one right over here out. And once again, when it lands 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 because the person they bought something from will deposit that money. And so 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 problem. Actually, it's a sum of an infinite series, and all that. And you can 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, $3.00 right over here, there's a lot more money in the system. You have this guy, who made this deposit, thinks he has $3.00. This person thinks they have $2.00. This person thinks they have one. So just in this example over here, we have one, two, three, four, five $6.00. So just right over here we have $6.00 in this system. And you might say, well, is this really money? 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 withdraw 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 if he really needs to buy an apple. And that Apple costs $1.00. So this is my drawing of an apple right over here. He does not have to withdraw this $1.00 out of the bank. He can write a check. So right now he has claims to all three of these dollars. He can write a check to the apple vendor, so $1.00. 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 it is essentially enabling-- this check writing-- is enabling these transactions to occur. So it's still enabling, either you could view it as 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, is to show you that the amount of money in circulation isn't really in the Central Banks, or not directly in the Central Bank's 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.