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How fractional reserve banking works

The money you deposit in a bank isn't just there for safekeeping. It can play an integral part in the entire money supply. This system is called fractional reserve banking. For a better understanding of how it all works, Sal Khan of Khan Academy gives you a closer look at deposits, reserves, loans and the multiplier effect.

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Transcript

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, let me get my pen tool right – I said, well, 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 our island. And then every year collectively they have, I'll just make up a number, 1,000 gold pieces that they get or at least this year. I'll call it 1,000 gold, right?

They have 1,000 gold coins that they get at the end of the year, and normally the farmers just kind of stash it under their mattresses or kind of dig up a hole and put it there, and I say, boy, what a waste, because there are actually good projects out there, 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 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 by-product of the 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. All right, so this is real estate, our building, and it's worth 100 gold. These are my assets, assets on the left hand side, liabilities on the right hand side. Then I go tell all of these farmers, and 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 1,000 gold pieces into my bank. So now I have this liability that I have 1,000 gold pieces liability, and why is it a liability? –Because I owe it to the farmers. 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 pay attention to them later. Let's say I put 10% aside, so I put 100 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 what? I actually need my money. 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 colour. I'll do it in green. 900 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 1,000 gold pieces come in – I kept 100 of it, and now I'm going to lend it to someone who has a really good project. 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 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 essentially dig these ditches.

Well, that 900 gold pieces then goes to the workers. The borrower borrowed them and then paid them 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, they're just like the farmers. They say, "Well, 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 900 gold pieces, and I take it as a deposit. So let me try to draw that as a deposit. I'm going to try and see, if this is 1,000, 900 might be about that. 900 gold pieces, so this is the farmer's 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 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, I don't need to keep all of this 900 gold pieces here. I could lend it out again for some useful project. So once again, I say, well, 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% of them will come at any given day, so let me set aside 10% of that.

So once again, I'll have 10% reserves, so I'll set aside 90 gold pieces, and then the other – let me do that in the lending colour – 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 on 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 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.

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 factory contractors, the people who build the factory. 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, I could continue this process, so forth and so on, and just so you know, it doesn't go infinitely, right, because every step of the way we're having a little bit less, and I'll do the fancier math on how to figure out how many steps we can do, but 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 keep all of those 810 gold pieces as reserves.

So this is my balance sheet after, you know, maybe if these transactions occurred all at once or 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. This is liabilities, right, these are deposits that I owe to people. Deposits equal liabilities, from a bank point of view, they're assets for those people. And then these are my assets. Some of them are cash money, right, in magenta, this 810, this 90, this 100. These are gold coins that are sitting in my vault, so that's definitely an asset that I have, and then these are loans, 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 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? Or notice, all 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 810 plus 90 plus 100 is equal to 1,000 gold. So there's 1,000 gold pieces, and that makes sense, right, because we had 1,000 gold pieces to begin with, and we didn't mine for any new gold or we didn't use any lodestones to turn lead into gold or anything like that. We just had the original 1,000 gold pieces, and there's no way to create more, they don't reproduce on their own, so we still have 1,000 gold pieces, and we can kind of view that as our narrowest definition of the money supply.

Now let's take another definition. Let's call this 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? Well, the farmers think that they have 1,000 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, this is 1,000 plus 900 plus 810, let's see, what is that, 2710? 2710 gold pieces, so 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 those numbers, you would have 2,710 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 they talk about the money supply. It depends how you measure it, and this is what people talk about when they talk about money being created. We had 1,000 gold coins, but because of this multiplier effect, people think that there are 2,710 gold pieces. In the next video I'll address the issue of whether they are correct to think this. See you soon.

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