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professor Klein Klein the younger I guess is the way you differentiate or climb the beautiful maybe she likes to be called she just gave her lecture on on money I want to follow up right away with this lecture on banking and the title of it begs a couple questions in your mind the first question is why should we have to set aside a whole lecture for banking because we don't have other similar type lectures for other industries like we don't have a lecture devoted to barbers or car companies or anything like that so already you should have some intuition that banks are somehow special in the economy and we really need to tease out what's so special about them the other reason that the lecture on banking is special is because when we refer to banks there's really two different types of banks that we can refer to on the one hand we have central banks like the Federal Reserve and we'll have more to say about that momentarily and then on the other hand we have private banks or commercial banks like the ones that you'll go to and that you have deposits in so we need to tease out what the differences are between them and what the relationship between these two forms of banks are so just to begin when we refer to banking what is it that we mean for most of us we consider banks as depository institutions and by this I mean you walk into them you get paid currency maybe you don't feel safe walking around the mean streets of Auburn with $100 in your pocket and so you prefer to go to your bank and and buy a deposit from them you exchange a hundred dollars worth of currency and they give you a slip of paper or an electronic receipt this as you now have $100 worth of deposit with them and the banks job is to keep your money safe for you the other form of banking and actually if if you ask a common person what do you do at a bank they'll give you two answers they'll say I go to a bank to make a deposit I also go to banks when I need to borrow money so if you're a student and you have a loan right now or if you've bought a car you probably went to your bank and ask for credit and your bank was the institution that issued you alone and that way maybe your parents are also banks I'm not sure but that's you probably don't trust your money with your parents I wouldn't with mine personally but that's that's what it is when we mean when we speak of banking and the special thing about this is is that we've got two fundamental functions of banks deposit taking and issuing loans and when they're separate and not intertwined together everything is perfectly fine but as we'll see when you mix these two functions together strange things start happen one of the first things that starts happening is we end up with some legal difficulties in contract law there's many difficulties with with the standard deposit banking contract I wasn't going to focus on that in this lecture per se because I have a follow-up lecture tomorrow on Austrian business cycle theory which is where the real economic problems of combining these two forms of banking together really come to the fore and so we'll discuss some of these economic problems tomorrow in the next 45 minutes what I really want to focus on is the repercussions to the money supply of the banking system combining these two functions together so first just as a recap because I know it was so long ago but when dr. Klein was talking about money she defined it as the generally accepted medium of exchange and when we speak of money as the generally accepted medium of exchange it's helpful to put a couple attributes on it that allow us to identify all the different goods that function as money in the economy so the first attribute that we have is that money always sells at what we can call par value when you go in to buy something and the price is ten dollars you know if you hand over a ten dollar bill that that is sufficient to pay for it if you you could have paid for it by selling a stock that you own but the proceeds of the stock would depend on the market price at the time and so that doesn't sell at par value but the money in your pocket the currency that you have always sells at a pre stated value par value as the case may be and the other attribute which is important in defining money is its on-demand availability whenever you go into a store and you pay ten dollars that ten dollars instantaneously pays for the good that you're purchasing you could have used a bond or some credit instrument to pay for the good that you're buying but then you would just delay the moment in time when you actually get the value if it's a bond or you would delay the moment in time when you actually have to pay for the good if you're buying it on credit and so when we speak of a generally accepted medium of exchange we're really referring to two specific qualities that are inherent in that good its value has to be available at par and it has to be available on demand and once you understand these two criteria that the good functioning as money has then you can go out there in the economy and start looking for things that are actually functioning as money what are the specific goods that you'd look for and so if I asked you to go there and count up the supply of cars in the economy you come up with a definition of cars and then you go out there and you count them and that would be fairly straightforward if I ask you to do with money what you really need to do is look for all the goods that have these types of qualities so some of them are pretty straightforward currency the notes in your pocket the change the change you have in your wallet those things have these two qualities and so those are definitely money your bank deposit account also shares these two qualities the value is available at a predefined amount and it's available on demand so we consider that to be money there's some other components that we can also add into this but for the purpose of this lecture we're just going to limit the money supply to the stock of currency and the total amount of deposits in the economy we'll ignore some of these other items which for the most part are relatively insignificant or minor compared to these compared to currency and deposits now if you define the money supply in this way as the stock of currency plus the stock of deposits then we have to look at who it is who supplies or creates these two components in the money supply so the first supplier and this has to do with the currency component more than anything is the institution we know as a central bank the Federal Reserve in the States the Bank of Canada in Canada the European Central Bank for the eighteen countries that use the euro as a currency in Europe etc etc this is the institution which is charged with issuing currency and has ultimate control over the money supply a formal definition might be to say that it's the monopolist producer or supplier of money in an economy so the Federal Reserve is the only institution which can issue and supply I should say the only institution that can supply money in the US economy the Bank of Canada is the only institution the monopolist institution that can supply money within the domain of Canada so on and so forth and the central bank in addition to being the monopolist supplier of money also has a couple subsidiary roles one of the most important ones for our purposes in this lecture is it's one of the primary regulators of the commercial or the private banking system that is the bank that you go to to make a deposit and then on the other hand we also have commercial banks or private banks and it's these banks that you go to when you want to buy a deposit you probably don't consider it as buying a deposit but when you your bank and you give them $100 currency and they give you the slip of paper that says you have a deposit for $100 you've just converted your currency or exchanged your currency into a deposit you've purchased a deposit and they have sold that to you and so we have two different institutions the central bank which controls the currency component of the money supply and then the commercial banking system or the private banking system we could call it which controls the deposit portion of the money supply now to understand the process through which these two institutions control the money supply it's helpful to take an accounting point of view so I just want to get some terminology out of the way here in accounting if you haven't taken it before everything gets divided into either an asset or a liability an asset is something that you own a liability is something that you owe assets can be comprised of present goods things that actually exist right now or they can be claims to future goods you have a sheet of paper that says the holder of this sheet of paper will get $1,000 one year from now that's an asset but it's a claim on a future good the liabilities are claims against your assets in an accounting there is the fundamental equation of accounting which is assets always have to equal liabilities these two components necessarily have to be equal to one another so this terminology will be helpful as we go forward and looking how central banks and private banks control the money supply so first we'll start with central banking so the Federal Reserve and that was the part where everybody was supposed to start booing it's better the Federal Reserve thank you for that by the way was created in 1913 by act of Congress and the stated purpose initially was to have an institution that would supply an elastic currency and elastic money supply and by elastic the argument was that there are different needs of trade there are different demands to use money they they Evan flow seasonally during during the year also over longer periods of time and this institution will create more money supply more money when the needs of trades are stronger or higher this institution will also be able to contract the supply of money when the needs of trade are lower as an example for that seasonally in the United States the Christmas shopping period and the summer holiday season traveling season typically correspond to people increasing their demand for money and the Federal Reserve responds in those two periods of time temporarily to increase the supply of money to meet the needs of trade and then afterwards when the needs of trade the demand for money subside the Federal Reserve acts to contract the supply of money so that was the original reason why we have the Federal Reserve and we can divide its rolls its primary roles into two different categories one is to control the quantity or the supply of money and it does through this through what we call monetary policy more on that in a moment and it also serves as a banker for banks and for the federal government now with monetary policy the term that we use to describe the means through which or the process through which the central bank controls the money supply is an open market operation it's a fancy word or it's a fancy term for a very simple operation all it is is a purchase or a sale of a government bond when the Federal Reserve wants to increase the money supply all it has to do is sell currency on the market and it buys something in the thing which it buys is a government bond in this example that I've got up here right now the Federal Reserve has bought $100 worth of US government bonds and it has paid for those bonds by issuing $100 worth of currency it could have been to you it could have been to you it could have been to anyone as the case may be is actually to what are called primary dealers these are the 30 largest banks in the United States now in these open market operations then whenever the central bank wants to expand the money supply all it needs to do is buy an asset a government bond so if it's Christmas shopping season and people's demand for money has increased the Federal Reserve responds by increasing the supply of money outstanding in the economy in this example we're gonna limit it to currency and we'll we'll generalize it a little bit more fully later on the way that it's going to do that is by buying government bonds from these thirty primary dealers and so the balance sheet of the Federal Reserve would change by adding ten dollars of new currency into the economy outstanding and it's gained ten dollars worth of assets if you want to find out what the supply of currency is in the economy one way to do that is just to look at the asset side of the balance sheet of the Federal Reserve in fact during the crisis if you remember the term quantitative easing became quite popular quantitative easing was just a different way to explain an old process the old process being the standard open market operation and quantitative easing just referred to the fact that the central bank controls the quantity of money by buying up government bonds so every time the Fed buys a US government bond it expands the supply of money currency in this example if it wants to contract the supply of currency all it needs to do is sell off its supply of bonds now to give you an updated view on what the Federal Reserve's operations actually look like here is the balance sheet from a week and a half ago on the right hand side we see the liabilities and this is a little bit more complicated than the example that I just gave you in the previous example the only liability that the Federal Reserve had was currency in this example there's three liabilities currency makes up a fairly large component of it almost 50% and these are in billions of dollars by the way so there is 1.7 trillion dollars worth of US dollars outstanding 1.7 trillion is a lot if you have if you have 300 plus million Americans that's $5,000 per person I guess nobody here is walking around with 5,000 in their pocket although maybe maybe you are I'm not so where's the $5,000 you have to keep in mind that the CIA is doing special ops down in some country and now I hear a drone coming in and of course that cost a lot of currency to buy and and of course foreigners also if you go to less developed countries it's quite off common that you'll see US dollars circulating as currency so that's the total supply of currency that the Fed has issued up until now and then there's two deposit accounts one is for the Treasury so this is one of the US government's bank accounts which is held at the Federal Reserve's is 245 billion sitting in the account right now take that debt ceiling and then there's the bank deposits and these are deposits that private banks have at the Federal Reserve just as you have a bank account with a private bank those private banks keep bank accounts at the Federal Reserve and just as you use your private bank account to enact payments private banks use their bank account at the Federal Reserve to also make payments so we have a total amount of money on the right-hand side or liabilities outstanding of about 3.9 trillion dollars and of course those liabilities are fully backed by assets which the Federal Reserve has bought over the years the lion's share almost a hundred percent of those assets are tied up in US Treasury bonds US government bonds right now and then there's a couple minor items allegedly there's a gold holding somewhere that the Federal Reserve has worth eleven billion dollars and then there's some other assets included in these other assets or small items if you go to Washington DC which is where the the central office of the Federal Reserve System is it's a choice piece of real estate right on Constitution Avenue sand the Lincoln Memorial you can imagine that building in the land is worth quite a bit so that would be some an example of something that's included in those other assets there but be that as it may the Federal Reserve has bought three point eight trillion dollars worth of US government bonds in the past and has issued three point eight trillion dollars worth of money some in the form of currency and then some in the form of banks deposit accounts another way to think about this is if I were to buy your car I could pay you in one of two ways I could either pay you cash but depending on your car you probably don't want to receive that much cash you would probably prefer that I give you a check or if I just electronically transfe the money into your bank account that bank deposit item up there on the liability side that's what the Federal Reserve does more typically when it a government bond from a bank it'll buy a billion worth of government bonds from JP Morgan and then it will just electronically place 1 billion dollars worth of money into that banks bank account with the Fed JP Morgan could also ask for currency if it wanted but there's there's limits to that right most most people would prefer to deal with their their bank account directly so we've got this monetary policy these open market operations which are coordinated through these primary dealers and I want to talk for a moment about the winners and losers if you want to refer to it in that way of open market operations now the fact that the central bank that the Federal Reserve only deals with 30 primary dealers opens itself up to some amount of collusion we're only going to buy government bonds from 30 different people in the economy 30 different institutions and so it's a little bit unclear whether there's really competitive forces they're getting the best price of the best deal for the assets that they're buying and of course those primary dealers are themselves rewarded by banking fees and associated fees of being the the supplier of government bonds the seller of government bonds to the central bank then of course there's the government itself so imagine if there was an institution in the government who was always willing to buy bonds that you issued sponsor your creditor by your credit you would probably pay a lower interest rate than would otherwise be the fact and since the federal reserve currently owns almost four trillion dollars worth of US Treasury debt which is about 25 percent of the total amount outstanding you can imagine that the federal government pays a lower interest rate on its debt than would otherwise be the case there's always a ready buyer for for Treasury debt as a result of these open market operations but it goes even deeper than that the Federal Reserve like all central banks is not charged with creating private as normal private businesses would be it's just charged by Congress with controlling the supply of money making sure there's an adequate or in in dr. Klein's lecture an optimal supply of money in the economy at the end of the year of course it's holds a portfolio that has four trillion dollars worth of bonds in it and those four trillion dollars worth of bonds payoff interest every single year the Federal Reserve uses this interest to pay for its operating expenses Federal Reserve economists salaries and keep the it's on and things like that and then it remits the profit back to Congress or back to the Treasury at the end of every year last year it amounted to 90 trillion ninety billion dollars the year before it was approximately 82 billion I think give or take so it's not chump change and effectively what it does is create a zero interest rate bond for the United States government the United States government issues a bond the Federal Reserve buys it the Treasury pays interest of the Federal Reserve but then at the end of the year all the interest minus operating expenses which are fairly minimal get remitted back to the Treasury so it pays lower interest rates for people who buy bonds and it pays zero interest that Treasury pays zero interest for those bonds which are purchased by the Fed and of course there's the issue of how profitable is to issue currency itself so if you've got a one or a two dollar note in your pocket do you know what the cost of production is for a one or two dollar note yeah it's about five cents okay give or give or take if you've got a five a 10 a 20 or a 50 it's around 10 cents if it's a hundred it goes up to about 12 cents because there's added security features the higher the denomination of the note but imagine that it costs 12 cents to produce $100 note and then the Federal Reserve gets to purchase $100 worth of bonds which pay off interest with something that only cost 12 cents to produce it's a pretty good money-making business if you were to ask me so there's this issue and then there's also the fact that there's no issue there's no cost whatsoever to issuing reserves which is the preferred method that a bank would choose to be paid in for the bonds that it sells so for every time that the Federal Reserve buys a billion dollars worth of bonds from JP Morgan or Bank of America for example in a stroke of a key it's a computer entry with no cost associated with it it's able to produce the billion dollars to pay for those bonds out of thin air pretty good business so that's the central banking side of things and then of course there's the private banking industry as well which you'll go to first and foremost for your deposit for deposit facilities now deposit banking initially emerged in the Renaissance as what we call Goldsmith bankers this is back when gol function directly as money and of course you probably don't feel secure walking around with gold coins it's also maybe a little bit inconvenient because gold weighs quite a bit and so you would go to a specialist a goldsmith banker who would provide services of safekeeping vaults that are specialized to keep your role safe and also to offer you some convenient services and you would of course pay them for these this deposit-taking service and Goldsmith bankers if you if you're into etymology the science of word origins Bank derives from Latin Banco de Banco is a bench it still is in Spanish and Italian and the bench refers to the bench that was in the central square like the Piazza and Italy where Goldsmith bankers would sit to conduct their business under watchful eyes of the general public just to make sure that nobody was getting ripped off everybody would see exactly what's going on and so this was the origin of Goldsmith bankers and initially several hundred years ago Goldsmith bankers exclusively operated as deposit-taking institutions so you would go with your hundred dollars and you would go you would go to your Goldsmith banker and say I would like to make this deposit of course it wasn't a hundred dollars it was some of gold they would give you a slip of paper that says the bearer of this paper or this person is entitled to one hundred dollars of gold whenever they come in and ask for it and then they would turn around to their vault and they would put that gold or the hundred dollars that you gave them in the vault the vault today is what we call a reserve account and so under 100 percent or full reserve banking the banker takes your money gives you a slip of paper that entitles you to it to claim it whenever you want and then places an equivalent sum of money into the vault or the reserve account and of course that reserve account is important because you're gonna walk in at any moment's notice and ask for your money back and they have to make sure that it's available to them now you can see from this that in 100 percent reserve banking the bank itself has no effect on the money supply the composition of money is altered but not the absolute level of it remember that for our purposes in this lecture the supply of money is composed of the amount of currency and the total amount of deposits outstanding originally if you walked into your bank with $100 worth of currency we can imagine that the money supply is 100 dollars and it's composed exclusively of currency the moment you give it to your bank the currency comes off the market and it is replaced by a slip of paper a deposit note which says now you have $100 worth of deposit the composition of the money supply went from being exclusively in currency to now exclusively in deposit but it's still only 100 dollars at the end of the day so full or 100% Reserve Bank's affect the composition but not the absolute level or supply of the money supply now it's interesting to ask yourself and dr. Klein touched on this briefly and I just want to expand on it it's interesting to look at what constitutes the demand to hold money like why do you even want to hold money the demand for money in answering this question there's a nice device that ludwig von mises developed in human action which he calls the evenly rotating economy so in the evenly rotating economy he imagines a scenario where every day goes by but the exact same thing happens every single day you wake up in the morning you buy breakfast and you incur it expense you get paid at lunch maybe in the evening you buy some more goods it's always the same goods it's always the same amount of money it's always at the same time and as time passes but the exact same things happen every single day Mises asked the question what happens to your demand for money under this scenario now the money that's sitting in your pocket the currency that's in your pocket right now does not bear interest so there's a real cost associated with holding on to it the cost in some sense of the word is the forgone interest that you could earn if you knew exactly when all your expenses would be you wouldn't hold on to money you would buy a financial asset like a bond of the appropriate maturity that would mature and earn you interest on the interim period and then you would be able to take advantage of interest and also be able to pay for the goods that you want to be and so Mises uses this device to say that if we had this evenly rotating economy where we know exactly what's going to happen we know when all expenditures and revenues come in they're in their timing and their magnitude we would never demand to hold on to money but if we upset this balance a little bit and we introduce some real uncertainty so you're not sure how much dinner is going to be you're not sure how much is going to be next month or you don't know if you're gonna get sick and you have to incur an expense at the hospital then all of a sudden you start protecting yourself by holding on to money and this protection against uncertainty that can creep up in the future is the primary source of the demand to hold money now it's interesting then because you can't even forecast when you're going to need money you're holding some amount of money because you are protecting yourself against some unforeseen event in the future but you don't know what that event is gonna be maybe get sick maybe you won't maybe you'll buy a more expensive dinner and maybe you won't but you protect yourself by holding money and it's important to recognize that you yourself where the money holder doesn't know when they will demand to hold money it doesn't know what eventualities them to want to use money and so it's impossible for an outsider who's not you to know when you're going to use money or to make an estimate or a prediction about when you're going to use your money and it's important because when we go into the next stage of the evolution of banking and we focus on fractional reserve banking banks use this pretense of knowledge that they can estimate or forecast when you are going to demand money to change the banking system so the argument got used over time that the money which was sitting in your bank account is idle sure every now and again you go in and you ask for some of your money back but most of the time it's just sitting there and you never seem to ask for it most of you could probably sympathize with this point of view hopefully you have money in your bank account which is not being used all the time right you never go in every single day and ask for 100 percent of your deposit back and so banks use this presumption that the money which was sitting in your bank account which was not being asked for withdrawn was idle or going unused to make an argument that they were eligible to use that money put it to productive use now if a bank makes use of some of your deposit maybe they'll make a loan or an investment and they'll be able to earn interest or profit off that and they'll be able to start reducing the banking fees that you pay so customers were also attracted to this type of option because normally under full reserve banking you would have to pay for your depository services just as you would with any other type of deposit a storage locker that you use or a safety deposit box or any thing of that nature and by banks appropriating and using deposits that were entrusted to them we had the emergence of what we call fractional reserve banking they were no longer holding all of the bank deposited in the form of a liquid Reserve account but they were only holding on to a fractional portion of it and really as we'll see in the example that we're going to go through here in a couple over the next couple of minutes what the bank has achieved is adjoining of the two previously separate functions deposit banking and loan banking into one specific type of Bank so here I've got just a fairly stylized balance sheet of a fractional reserve bank from the bank's point of view well actually from your point of view a deposit that you have is an asset but every asset needs a corresponding liability so that from the bank's point of view it's a liability and you can see that on the right hand or the liability side of the bank's balance sheet you've gone in and given that Bank $100 worth of currency they've given you a slit a sheet of paper or an electronic receipt that says you now have a deposit for $100 and with that $100 previously in the full Reserve or 100 percent Reserve example the bank put all of the hundred into the vault or kept it on on reserve now the banks only going to keep a portion of it in reserve in this case it's going to be ten dollars or ten percent of the deposit and that leaves $90 or 90% of the deposit available for the bank to do something else with now the thing that they're going to do with it is issue a loan or make an investment and this gets into the second function that most people associate with banks you go to your bank to take out a loan if you buy a house or you buy a car most people's first stop is to go to the bank and ask for a loan and so the first thing that I want to draw your attention to in this example is what we can call a reserve ratio the reserve ratio is just the ratio of the total reserves that a bank holds as a percentage of its deposit base so in this example it would be 10 over $100 or 10% and of course the difference one minus the reserve ratio are $90 in this case is what's available for the bank to be lent out now the question is what does the bank do with that loan well it issues it to somebody to go one by a house but then when somebody buys that house what happens the $90 changes hands and goes to the cellar of the house and maybe the seller of that house doesn't feel comfortable walking around their town with $90 and so they go to their bank to make the deposit which only introduces a second bank into the example the second bank of Auburn here and so that $90 loan which was issued by the first bank of Auburn was used by somebody to purchase a good a house and then was re deposited into a second bank which you can see reflected in the deposit of the second bank of Auburn $90 of course then that second bank of Auburn is only going to hold on to a fraction of that deposit if it's the same 10% that the first bank used that would mean $9 that it puts into its reserve account or its vault which frees up 81 dollars that that bank can then use to issue a loan so somebody else is going to come in looking to take out a loan buy a house buy a car the second bank of Auburn is going to issue the loan for 81 dollars that person spends the 81 dollars buys the house the seller of the house takes the eighty one dollars and deposits it in their bank the third bank of Auburn in this example and so you can see that the process is going to continue where every single loan that a bank makes ends up being a deposit in a different Bank now if you were to look at this and think about what the money supply was how we defined it at the beginning of the lecture we said it's just the sum of all the currency and all the deposits which are outstanding so originally before we even went through this example we had a hundred dollars worth of cash which this person our hundred dollars worth of currency that this person deposited in their bank the mon y supply was 100 dollars and after we go through this example we can start to see that the money supply has changed first of all in composition there's no longer currency outstanding incidentally do you know where the currency has ended up in this example it's not circulating any longer it's sitting in the reserve accounts its vault it's cash which the bank has put into the vault so it's that ten dollars up here which is part of the hundred dollars of original currency it's the nine dollars right here it's the eight dollars right here so on and so forth but then if you tried to define what the money supply is what the total quantity of money is you have to go through the liability side of all these banks balance sheets because the money supply is no longer composed of just currency it's now composed of deposits there's $100 deposit in the first bank of augur and a $90 deposit in the second bank and $81 deposit in the third Bank the 73 dollar loan I'm not going to put in the next bank but the 73 dollar loan which the third bank of Auburn is issuing is then going to get redeposit into the fourth bank of Auburn I guess and that will also add to the total supply of deposits and if you were to add this all together you'd get a geometric series where the total amount of deposits outstanding is a hundred plus 90 plus 81 plus 73 + 62 27 and the total sum of that if you took it to its full conclusion would be $1,000 more on where the thousand dollars comes from in a moment now we've created new money but importantly there's no new wealth which has been created by this process the original amount of wealth in the system was the hundred dollars worth of currency it's just that the fractional reserve banking system has been able to multiply the original amount of money which was deposited into a greater supply of money but it hasn't been able to create wealth in any way right there's still only $100 which was originally deposited so this introduces the question of how can we best define the way through which the banking system multiplies these deposits and the way that we do it is through something that we call the money multiplier a measure of the money multiplier tells us or communicates to us a number about the banking systems that summarizes the banking systems ability to convert deposits into a total supply of deposits or a total amount of new money and I'm not going to prove it to you mathematically you can just trust me on this but the money multiplier is just the inverse of that reserve ratio so whatever that reserve ratio is as a percentage remember it's just reserves divided by deposits if we take the inverse of that we're going to get the money multiplier and if we multiply the money multiplier by the deposit we will get the total amount of money supply example in the summary example that we just looked at the reserve ratio in every single Bank was 10% the first bank kept dollars on the initial deposit of 100 the second bank kept nine dollars on the deposit of $90 the third bank kept eight dollars and ten cents on a deposit of eighty one dollars etc etc so the reserve ratio is always ten percent the inverse of 10 percent is ten the initial deposit was $100 100 dollars times 10 is 1,000 dollars which is the total supply of money so again the composition of money changes from being composed of currency to being composed of deposits and also the total supply of money grows by 10 times and then you'll note that the higher the money multiplier the greater the money multiplier is the greater the supply of money will be also right for any given initial deposit into the system the larger the money multiplier the greater the supply of money will actually be so if we had have changed the example and had all of our banks keeping only 5% of their deposits on reserve the inverse of 5% is 20 20 times an initial deposit of $100 would be $2,000 the banking system would have had an even greater ability to create money in that scenario or if we drop the reserve ratio down to only 2% so each Bank if you went in and deposited $100 into your bank that Bank would only take two dollars put it in the vault and it would issue a loan of 98 dollars the inverse of 2% is 50 that's the money multiplier so if you deposited that hundred dollars the banking system would be able to create 50 times 100 or $5,000 worth of total deposits or total money supply and to take it to its logical conclusion if the banking system held a reserve ratio of zero the money multiplier would be the inverse of zero which is don't do what my students do which is put put you know try to put the inverse of zero into their calculator so that you get error don't do that don't you ever get that joke it's not an error it's at the limit it's infinite and you can imagine what this would look at you would walk into your bank and give them $100 for a deposit that Bank would keep nothing in the vault which means that issue is a loan of $100 that loan of $100 gets redeposited in another Bank that bank keeps nothing in the vault which means it issues a loan for $100 and the process just continues infinitely of every single bank issuing alone in the same amount as what got deposited in it in which case the money supply would be infinite so we can see that the control or the expansion of the money supply by the fractional reserve banking system is a function of the reserve ratio and it acts through what we call this money multiplier now to go back to the full reserve banking system that we looked at initially in the full reserve banking system the reserve ratio is 100% you go in and you give your bank a $100 deposit that bank puts $100 in the vault as cash well if the reserve ratio is 100 percent the inverse of 100% is 1 the banking system has no effect whatsoever on the total money supply again it will change the composition of money money will no longer be in currency now will be tied up in deposits but the overall level does not change at all now it's important when you look at this example to recognize that no individual bank no individual fractional reserve bank has any effect on the money supply it's the banking system taken as a whole which really makes the difference because if you looked at any individual banks balance sheet all that you would see is it takes in a deposit it puts a little bit in the vault it issues the rest as a loan and that's that the action happens when the loan gets redeposited into a different bank and that's where the money multiplier becomes important so don't go and accost a banker by the way and accuse them of creating money because they won't have any idea what you're talking about I did that by the way when I first learned that don't don't do it don't do what I do it's a true story they won't have any idea what you're talking about because it's the banking system as a whole which is able to create money not not any individual bank now this analysis is is thoroughly Austrian Herbert Davenport was the originator of the of the analysis in 1913 all the bad students in the back like lucas Englehart they can't see but herbert Davenport's name is right here in front of me if you turn around the good students in the front can turn around to see kind of the top in the center there and it was more popularized by chester phillips in 1931 he popularized it for the profession chester phillips by the way wrote a very wonderful book on the Great Depression which is fairly thoroughly Austrian analysis and Ludwig von Mises and the theory of money and credit back in 1912 alluded to a similar process maybe not in such formal terms but the essence of the process is is there in Mises as well so it's a thoroughly Austrian analysis understanding the effects that the banking system has on the total supply of money now if the money multiplier amplifies or works to amplify the effects of a deposit into the banking system it also works in the other way it contracts the money the money supply when a de positives withdrawing because if you go to your bank and you request a deposit or if you swipe your debit card the bank needs to come up with money to pay for that where do they come up with the money first they're going to look into the reserve account so they go into the vault in the back or now it's in cash points banking machines that's where the cash actually is they're gonna see what kind of money they have available currency to pay you if they have an insufficient amount they're going to have to start calling in or selling off some of their loans to another buyer in order to raise currency to pay for your Redemption request but this introduces some limitations that the fact fractional reserve banking system has in its ability to operate the money multiplier and to create the total supply of money the first limitation is the total supply of reserves that it has but the central bank supplies reserves on demand if a bank ever needs reserves that's one of the primary roles of any central bank is to supply those to a private bank so that's not really a true limitation in any sense of the word on a fractional reserve bank the other limitation is in our own hands it's the demand for currency because imagine if you got $100 cash and you decided to not deposit in your bank as long as you don't deposit it in your bank that bank will not be able to issue a loan against it that loan that doesn't exist anymore won't get redeposited anywhere else so the fractional reserve banking process comes to a halt in fact if you wanted to end the fractional reserve banking system all we all need to do is stop depositing our money in banks and just use currency now when you combine the two systems together you get something which is very special it's almost like a pyramid scheme so first the central bank creates reserves X Nilo from nothing right all it is is a computer entry we're gonna buy a billion dollars worth of US Treasury bonds from from Bank of America and I'm just going to with a keystroke debit 1 billion dollars into their reserve account that they keep with me then the fractional reserve banks Oh Bank of America in this case is going to have this billion dollars worth of reserves with which it can issue loans and it's going to do so until it gets to its desired reserve ratio by the way the reserve ratio is set by the central bank in many cases and so the Federal Reserve legislates a reserve ratio that all banks operating in the United States actually need to maintain and the result of this is a pyramid scheme so what I'm gonna do is is put up both balance sheets here together at the top we have the Federal Reserve systems balance sheet at the bottom we have the fractional reserve banking systems balance sheet these are the two banking systems that we can talk about so first focus on the Fed at the top there on the right hand side the liability side of the Fed's balance sheet we have 1,000 dollars worth of worth of reserves these reserves it's easiest for our purposes to think about them as bank accounts that the private banks hold at the Federal Reserve and it's a it's a bank for banks and of course those resource have been issued by the Fed buying government bonds from these banks in the past and so the thousand dollars worth of assets was purchased and the Federal Reserve created a thousand dollars worth of reserves to pay for those bonds then we get down to the fractional reserve banking systems balance sheet at the bottom so you can see that just as there's a thousand dollars in reserve for this in the central bank there's a thousand dollar reserve as an asset with the fractional reserve banking system as well and in the fractional reserve system here we've got $10,000 worth of deposits those banks have held 10% of that 10,000 on reserve so that's that's the $1,000 worth of reserves and that's freed up $9,000 with which they could invest now in the previous example that we went through the investment was only in loans mortgages car loans things like this here I've divided them up into two categories these banks have issued loans mortgages we can call them worth $8,000 and that's an asset to the bank because when you pay off your mortgage you're going to give the money back to the bank and then the fractional reserve banking system has also bought $1,000 worth of US government bonds so it'll it holds in its assets three different types there and then we could ask what would happen if the Federal Reserve decides to expand its balance sheet if it decides to create reserves out of thin air so it decides to buy 1,000 ba $1,000 worth of bonds and to create $1,000 worth of reserves which is the new entry that I've created there but then the question is where did $1,000 worth of bonds that the Federal Reserve bought where did they actually come from I came from the private banking system and so to show that effect we need to update the fractional reserve banking systems balance sheet at the bottom here and so of course the government bond balance goes to zero they sell off their thousand dollars worth of bonds to the Fed the Fed gives them $1,000 worth of reserves which means that the fractional reserve banking systems balance sheet has gone up to $2,000 worth of reserves but now of course for the banking system there's a bit of a problem because the reserve ratio which was originally only 10% is now 20% they're holding on to 2000 dollars worth of reserves against $10,000 worth of deposits which means the banking system is going to start issuing loans to get its reserve ratio back down to 10% and as the case may be is going to have to issue an additional $10,000 worth of loans which will then be redeposited into other banks increasing the total amount of deposits and now we've got a reserve ratio in the banking system which has reverted to 10% the minimum there's $18,000 worth of loans outstanding and there's a total amount of deposits outstanding for a to $20,000 and so in this example what we've done is the central looked at how the central bank was able to buy $1,000 worth of government bonds at no cost to itself just a computer entry of creating $1,000 worth of reserves and the total effect on the money supply is a doubling or an increase of 10,000 so at no cost to the central bank and no cost to the well to the central bank $10,000 were able to be were able to be created out of thin air I'm gonna end with a bit of a story so you could probably look at the system and recognize it's a little bit unstable there's always the threat that you're going to go in and ask for your money back and make a withdrawal and so we can comment on the fractional reserve banking system by noting how inherently unstable it is if anybody comes in and requests for more than 10 percent of their deposit the banks don't have enough on reserve to actually honor these Redemption requests the solution to this was brought about by DePaul insurance and all of your bank accounts in the States are insured by Federal Deposit Insurance Corporation so nobody really cares if their bank goes bankrupt anymore but this only means that banks don't have to attract customers by acting prudently they can now make risky investments they don't have to worry about this aspect of their business models so much which only means that the banks become inherently more stable and so the Deposit Insurance momentarily solves one problem the risk of the bank going bankrupt and depositors not being able to be paid out but introduces a new problem that it induces risk-taking into the banking system as a result now there's an easy solution to this which is a return to 100% or full reserve banking which would eliminate all the risk tanki in the banking system also eliminate the need for costly bailouts to the banking system when there are high Redemption requests and would reserve return the money supply to normalcy I'll end there if anybody has any other questions though because I know it's a complicated topic just come on as you mean during the break okay thank you you [Applause]