Banking 4: Multiplier effect and the money supply
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- čas přidán 7. 10. 2008
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How "money" is created in a fractional reserve banking system. M0 and M1 definitions of the money suppy. The multiplier effect.
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Last 2 minutes, are actually so important!! Youre a legend, thank you for explaining it so simply
Indeed, now I know why we are always on inflation
Oh, now I know that the point is not about there's too much money supply,the point is if the growing of real wealth can catch up with the money supply, it depends on those investments are good or bad.
In the past,I only look at the money supply and I always think there's are bubbles and bubbles,but now I realize that I never consider the real wealth.
Thank you for your amazing lesson, I love it so much!
WHY WE ARE IN SO MUCH DEBT is another good video. It provides one of the simplest, clearest explanations yet of our monetary system. Highly recommended.
thanks , mate, you're really good at explaining. I've been looking for such an explanation for a long time.
Great video and series! Thanks
One thing I would mention is that the increased wealth is subject to people buying the extra apples that are produced. If not, or if the price of apples even goes down due to increased supply, then the irrigation loan was perhaps a bad business decision. Therefore the irrigation company cannot pay back their loan.
This video will never get old. Thank you
I have an exam tommorrow and suddenly i have found a great teacher in you.
i love sal's reveiew and expand teaching technique. inspiring
2:28 it is 90 not 900 as the reserve money not lend out
Hey Sal,
Nice video, it explains the multiplier effect well and you also inadvertently explain how we came to the GFC. When you say that as long as the bank is investing in projects that create wealth, not money, then the system works. Sure there will be ups and downs but for the most part it is a reasonably stable system. However, what happens when banks start investing in options and derivatives. These don't produce wealth, only money, and therefore the system will crash time and again.
Sal, how does this example of the fractional banking system stack up against the broken window fallacy?
That equity of 100gold isn't it should be counted money as per M0 ?
I don't get it please reply.
This is so true. Thank you for your great video. I remember back in the 80's our union visited my work place and asked all the workers to sign a payee agreement. This would allow our employer to deposit our PAY directly into our bank accounts. This is simply adding to your equation and giving the banks control of our money. Shortly after this was complete, the government placed fees on all our account for withdraws and deposits. We are suckers.
great vid!! help me a lot in school and in life!! keep them up~~~~~
fantastic;) please continue same video to explain more about inflation. how the government decides how much money to print and why.
so you lent out 900gold to the irrigation project...where on the diagram does it show the 900g that they paid back? Incuding or excluding interest.
I just started watching this series of videos on banking. I saw at the end of this video deflation takes place. Keep in mind- between 1913 and 2010 there was about 8,458.10% inflation. And between 2005 and 2010 it was 14.29% inflation. That’s a big difference between this video and the real world.
@josvazg I don't get your point. You can assume that the investments in Salman's example complete immediately. Suppose the investments take 1 year to complete, what is the impact of having 2710 M1 and 1000 apples in the first year?
Hi,
firstly before i start asking my question, I wanted to say that your videos are great, easy to understand, and are really helping me out! Keep up the good work :)
What i wanted to ask is that the (in real life), who makes the initial 'deposit' (M0)?
Does this represent the higher-powered money that banks borrow from the central bank at the given base rate? i.e. some money is kept in reserves and the rest is lent out to borrowers?
Kind regards and thank you in advance!!!
@josvazg you are missing the knock on that happens during construction of the plant ie.. building materials, steel, crane hire, consumption by workers ie. lunch at site
Fantastic video.
Your video's are so well laid out and explained I just wish you knew what you were talking about. I was with you 100% until you failed to realize that this process does create massive inflation when you remove it from your vacuum example and place it into the real world. Simply explained, for those investments to produce capital outside of your vacuum they require people to actually purchase the goods. Now assuming most people place most of their assets in the banking system, money will have
Thank you, I was about to make the same point when I read your comment.
Is there a reason that M1=e*M0 as the formula continues? Is this related to exponential decay?
Thank you for this very enlightening video, however what happens when all the people in village demand their 2710 gold pieces when only 1000 gold pieces exist? I'm assuming you write them bank notes.
@Anduy
For more detail you can go to Huerta de Soto's videos (there are some in Spanish) but using one simple example he used:
Suppose you are in an island and your life support are some "berries" you costly collect from high up in the trees.
Your investment is save enough berries to stop collecting them for a few days so you have time to prepare/build a long stick/handle to get the berries easily.
This is the first time I actually understand how money works
sorry,
what happens to the cash when it is used to pay back loans?? does the bank keep that cash for itself??
10:55: "the pie of apples got bigger." I wish my apple pie got bigger lol. Great explanation here, Sal.
For those wondering about the deflationary pressure due to a system that's running better than before, don't forget that the original depositors, the bank, and the borrowers are all making profits that never showed up in the picture.
Whats up man, extremely nice account that you have here. Nice one.
Sal makes the point several times that the money represents wealth. Wealth is something that adds value to society. If people start borrowing money to buy into more apples than society wants, then you're going to get a bubble. When all those extra apples don't sell, and people don't get money back to repay their loan, some will default. The bank won't have that money coming in any more to back up the liabilities (even less than before). This is when bank's balance sheets are ruptured (bankrupt).
Commercial banks create money, especially under the fractional-reserve banking system used throughout the world.
In this system, money is created whenever a bank gives out a new loan.
This is because the loan, when drawn on and spent, mostly finishes up as a deposit back in the banking system and is counted as part of money supply.
After putting aside a part of these deposits as mandated bank reserves, the balance is available for the making of further loans by the bank.
This process continues multiple times, and is called the multiplier effect.
The multiplier may vary across countries, and will also vary depending on what measures of money are being considered.
For example, consider M2 as a measure of the U.S. money supply, and M0 as a measure of the U.S. monetary base.
If a $1 increase in M0 by the Federal Reserve causes M2 to increase by $10, then the money multiplier is 10.
Could you explain what you mean by this?: "AUTHORIZES a monetary expansion in the bank transactions that occur as a consequence of the loan."
The problem here is, in the real world the supply chains are a lot longer and the bank doesn't know if their investment will lead to inflation or deflation. From what I'm seeing banks create inflation by giving loans. A bank can also decide which part of the economy it wants to inflate, by approving only certain projects or giving lower interest rates for those types of loans.
Now you can keep general goods inflation low, but pump all inflation into real-estate for example. If most of the bank's assets are in real-estate then the bank is creating a bubble in the real-estate market. This can be any other market, not related to the basket of general goods supply chain, otherwise the central bank will increase interest rates and stop the inflating bubble.
what is the total amount of money that bank of Sol can create from this fractional reserve system? Using 10% reserve ratio. Notice that for each loan the total amount that can be loaned is 10% less from the previous loan. Is the formula used to determine total loan money amount an annuity , sequence, or series?
Can you show us the formula?
Let us say that all those investments were being well-managed, and a surplus of 2000 apples is produced (as mentioned). Now, my question is how all those apples are going to be sold out since we don’t have its equivalent money in the market? Or is it the reason why the FED print out money? Thx
@i4Truth i believe you are right, eventually the total amount loaned out is a product of the initial deposit multiplied by 100 times the interest rate on the loans. I believe the multiplier effect would be less if people did not continue to deposit their money in banks. Also, changing interest rates on loans changes the equations as well. I think finance is badass.
Hi ananiasacts,
incredulous as it may sound - but all money is loaned into existence and whey they give you a loan - they don't create the money for interest - do they?
Credit markets reply on future GDP growth for loan re-payment
If you add "interest" into the equation, how do you expect the ditch builders to pay back the interest on their loans?
I have a QUESTION.I will be happy if someone culd answor it.
What if everyone want to teak out there money at sametime. What happend then?
The problem with this scenario is that the extra 1,710 gold pieces don't actually exist. Sure you say there is more wealth in the village, and you're measuring wealth in apples in this simple scenario. But M1 is counting the *money* (ie, the gold) that people think they have. The people in this village think they have a total 2,710 gold pieces. But they don't. They cannot withdraw that much from the bank because those investments did not create more gold pieces out of thin air.
And this is the fallacy of fractional reserve banking. It earmarks the same money for multiple uses, and as such if enough people want their money back, that money simply is not there. The bank just told the people that money was there, but it really doesn't exist. This is what leads to runs on the bank, which absolutely astounds me that you didn't even mention is a very real threat when using the fractional reserve scheme. Just like a classic Ponzi scheme, it only works if people don't want their money back (beyond whatever the tiny fraction of reserves is).
BANKS ARE NOT USING FRACTIONAL RESERVE BANKING for the credit side of the bank. Banks do not lend from deposits. Banks take promissory notes and exchange them for endogenous money.
There will be 2710 gold pieces, once everybody returns their loans. The 1000G with which the bank starts are not all the gold pieces in the country, it's the gold the bank has in the beginning.
But even if that were the case and there was only 1000G in the world and it was all stored in a single bank, then you'd just get deflation. Wealth is still created, but in the form of reduced price per apple. Let's say everybody gets to the bank and demands his money, the bank can just repay them with apples of equal value, or other currency instead. The point is there will be more apples after lending gold/money. That's better for everyone.
Very good lesson, however at 2:27 you changed the correct figure of 90 to 900.. Just wondering also when you say that the borrowers make at least the 810 or the 900 I guess you mean twice the original amount they had borrowed?
To all you sceptics fractional reserve banking works in that the money that comes from PROFITS from these investments goes to pay off the loans PLUS the interest payments on those loans. The payments are MONTHLY and are factored into the GROSS PROFITS the company makes each MONTH. A company that makes enough money can pay off the loan payments, the wages of the workers and still yeild DIVIDENDS...
This was a very well done demonstration. Full props to whomever made it.
BUT!!!
He forgot the most important part. It's the last, and most important step --
"...and then there's a bank run... And the banker is hung."
The problem is that money has to obey supply and demand as well. The people who get the money first are benefited greatly, those who get it last can get screwed. Hayek's (was it hayek?) famous brick layer.
at texas tech university in rawls college of business money m1 is cash coin travelers checks, and checking account deposits and m2 is m1 and savings deposits, money market mutual funds, time deposits and other deposits ; and another term interchangeable with your gold pieces would be call it currency, m1
also what if everyone was to run to the bank and ask for there money who gets the money? first come first serve ?
The fractional rule is a way to put a governor on money creation. So, it authorizes banks to loan out an amount that the fed is willing to create when the "borrower" redeems a loan proceed in a bank for, say, cash. When the bank where the deposit is made receives that check for cashing the fed electronically creates he money and reimburses the bank for paying it out.
The second part of that Fed rule is that the fraction of the deposit as 0.1 * x = loan amount AUTHORIZES a monetary expansion in the bank transactions that occur as a consequence of the loan. and the money supply is increased by 0.1*x for each transaction. (continued)
This model also has to assume that money comes 'in' from outside the system. This will allow the the interest to be paid off. There are more things that could be discussed, but for a simple model, this is good.
@kvn89 he doesnt show interest paid on money lent to the bank or money gained from loans to project to simplify the situation
Sal you say that the M1 is real as long this investments generate enough to pay de loans. But where that money to pay the loans comes from?. Wasnt this money created from the same fractional system? Thus adding more to de M1 in the economy.
Damn!! I was actually watching this and thinking "man, i guess fractional reserve banking isn't SUCH a horrible thing..."
Then i read what you wrote.
ugh... i failed.
Good post, good sir.
@kwak76, You are correct. That's why he specified if it's a "real investment". A properly functioning bank looks for collateral and assured payback, not just a promise of a good idea.
'Irritation canal' at 0.33... :-) That's what you feel after taking a bad dump...
'It will probably make you live happier if you realize this difference' (9.35) Nice said!
Isn't it $3710 if i add up the money of farmers+workers of irrigation+workers of factory?
Just some questions:
a) Why do banks need such a high margin of profit (interest) if any?
b) How come natural resources (like oil) can be legally owned by a country, private corporation or individual?
c) Why does Joe Doe, the ditch digger project genius, have to create income interest for the bank when the only thing it did was taking borrowed money in the first place?
As he said, if the ratio of gold to apples decreases then the economy will experience deflation - which means that your money is worth more and hence prices fall, although it's important to note that deflation isn't really as desirable a phenomena as it at first sounds.
However, the most likely scenario would be that the excess apples produced would be exported (assuming the existence of other economies in this example) which would lead to a further increase in GDP.
This is assuming if the people who receives the money keeps putting the money back in the bank right? What about those that they spend away?
Matt hue relic The most of the money still end up in a bank in the end
That's the assumption they use to hide the fact that banks create credit out of thin air, it's not a conspiracy theory it's a valid theory called 'credit creation theory'. Banks are not in the business of borrowing and lending, they're in the business of Credit creation. Our 'deposit' are loans which the banks own and then use to buy securities (give out loans), but they don't buy these securities (give out loans) in cash, they do it partly with cash and deposit it in your account. The electronic digit in your account is not against cash held or gold reserves, it's created out of thin air. This sounds illegal but that's the reality. The reserves held by central banks which as supposedly a way of keeping these banks in check aren't done in cash, they are credited to the CB account using the credit created.
That's primarily why the Total value of all currency printed and the total debt in the economy are preposterously different. Leverage is the word.
The total amount of Money Supply M1 that can be created is 10,000G. This is the result of the geometric series. 1000+0.9*1000+0.9^2*1000..... etc.
The result is 1/(1-0.9)*1000G = 10,000G
The only part I do not understand is when the bank lent money to the projects, you showed how the money comes back via deposits, but nothing was shown about them repaying the loan with interest. So not only would you get the capital back, in the form of deposit, but also the payment on the loan, Only some of the payment applies to the principle, and the rest is put in the reserve or lent again.
i'm not sure if i totally buy that argument. Production is surely what generates Wealth, but if the amount of money is increased, then the value of the money decreases, and so the wealth of the production would be offset to some degree by the inflation. Plus, in order to actually begin the production, you'd find out that the money your using isn't worth as much as it should be worth - thus you'll begin projects you can't pay actually pay for; prices will rise as you're constructing.
SAL YOU ARE SO SMART
Going back to the example here and the 2710M for 1000apples, the loan on 'new money NOT backed by savings' would be the same as stopping looking for berries when you may not have saved enough to be able to afford your project.
This crediting is called an interbank settlement and it happens only within the federal reserve. The banks themselves never see it directly. But the point is that these credits are de novo, electronic creations of currency and that money does not come from any particular source, it is just created. Once you know this the rest of the problem is self-evident. It's a fraud built on the public misperception that loans are paid out of deposits. I'm working on a video that will explain all this.
this can easily be remedied by simply having honest banking: Give people the option at the bank of 1- just putting the money in a secure location and be charged money, or 2- give the bank X amount of time to lend out your money and collect interest.
This way the money supply isn't increased, production and money lending will still happen, bank runs won't be a problem, and there won't be any misallocation of resources due to the trickanery of inflation.
So can the wealth in gold ever exceed 9000g?
And just for correction, the "10%" is taken from the reserve, but the remaining reserve is not actually deducted for a loan, that loan money is created from nothing. The reserve is untouched. The money that is created "borrows" the value of the reserve money, therefore devaluing that value. That is why they HAVE to add interest to the loan. Get it?
Even if we adopted a gold standard, people would still use credit or debit cards rather than actual coins because merchants would charge a premium for the hassle of having to have the gold/silver checked for authenticity, weight, etc. We'd be back to the way it was when banks each issued their own currency. The taxing authority of the government is a potentially much more stable basis for currency because the government can adjust the supply. You can always buy gold or whatever if you fear it.
@josvazg I agree. He makes a conclusion way to soon. He just took a random positive efficiency factor and ignored the factor of time.
Banking and fractional reserve is indeed a powerful tool for economic growth, as long as it serves public (democratic) interests.
I would say that most debt is for frivolous spending with investors making their money on that spending. One question I have for you is "How do you think the proliferation of debit cards has impacted the current crisis, since there is no paper currency or credit involved in the transactions?"
This lecture should be deleted form the Banking course, after the Bank of England stated that "reserves are not mechanically multiplied
up into new loans and new deposits as predicted by the money
multiplier theory". (Quarterly Bulletin 2014 Q1)
Please check me with this please; I'm new to all this:
"What confused me so far is the fact that he didn't add in the interest to and from the bank.. And the fact that the loans are practically still out there with interest as well as the success of the projects.. so that to me would make me wonder.. Because if everyone paid their bank loans with say a 10% interest, there would be 1090 G the first time (adding in the reserves), and with a 5% interest to the depositors.. 1050 G in liabilities are in the bank. The second round using the same application would mean that a different 900 G is deposited to the bank and after the process and success of this building project, 981 G is in the bank counting the reserves, liability is at 945. 810 G comes in and they don't loan it out.. It comes back as 850.5 G liability. Liabilities added up = 2845.5 G income expenses. While in the bank it totals 2881 in all its income and interest. The profit becomes bigger if more loans happen after the 810 G is received because otherwise you are being hurt by the 5% interest last given.. All in all, 35.5 G is made to use for upkeep, salaries, and taxes.. which.. if you consider that 1000 G comes from say a 1000 farmers.. it's pretty good cash for a small first bank.. not to mention the new business startups being successful and increasing efficiency in expanding the production curve."
I AGREE!!! This is not at all how bank money creation occurs.
Why do people like yourselves come to videos like these if u already kno more than what the videos trying to explain
Sean Dafny When I notice a popular video that misleads viewers, I feel an obligation to issue a warning, providing evidence.
@matthewdunbaris You make a very good point.
@Zander101084
That prices tales you whether people prefer to save or consume, if investing is cheap or expensive, etc.
Risk is also contained in that price. It interest rates are low it means that you get more money easily investing on the long run. In that scenario savings should be high (and consumption relatively low) as many savers are competing to get interest from their savings and are forced to lower "the price" (the interest)
"What if the whole thing produce less than 2710 apples?" That's depends on how many less. If we switched to 'full reserve' banking we'd end up with higher interest rates because people charge more to tie up their money for longer periods. That would mean slower growth. FRB is not the problem all by itself. I think the best fix would be to prevent banks from going public and require the owners to be fully personally liable for any losses. That really would ensure they loaned money wisely.
My math below has an error. It isn't 0.1 * x, where x is the total deposit amount. The banks are authorized to loan out 0.9 * x of their total deposits but, it is, in fact, not a loan at all. Because that 0.9 * x is simply created de novo in the bank settlement that follows.
I think the problem that most people have is that it is impossible for both the 900 and 810 debts to be repaid if there are only 1000 gold pieces in existence.
Many thanks, appreciated it ;-)
What are YOU talking about? In order to lend something to someone, you need to surrender any and all access to that item (money). For example, you cannot lend an item of clothing to a friend and still expect to receive some of its utility (heat insulation) while they're wearing it. How can one have access to all of their funds, while the 'borrower' ALSO has access to a majority of the exact same funds? FRB permits the simultaneous ownership of deposits by multiple bank clients.
What are the construction workers and others who got jobs from the loans of investors doing before this. Surely they were producing goods and services and getting money in return or they would only be living off whatever taxation you can get from the farmers. IF they were working, surely their share of gold coins would also be in the bank?
@mikek241 One point of disagreement from me. In a free banking system, you can still lend out that 900 pieces, but the lender's account SHOULD be 100 pieces after that. Likewise, the workers can deposit the 900 pieces, and the bank can lend out 810, but the workers accounts SHOULD be 90 after that.
You make it sound like these lendings suddenly wouldn't exist without FRB. They still would and the economy would still grow. Not as fast since lenders would be somewhat more scarce, but more stable.
The problem with fractional reserve banking is the 'I' or interest obligation it creates. where is that money supposed to come from? employers can only pay workers the total of the principal amount borrowed, and in turn employees can only purchase the amount of goods equal to the principal they were paid. However, there is still this 'interest' obligation to the bank, for this system to work, then the employees would have to borrow and pay interest. and the cycle continues...
This system works if and only if: everyone pays back their loans, demand for deposits as cash in one day never exceeds its reserves, and enough gold is mined/panned to cover the interest. Of course, more gold coins in the economy means each gold coin will claim a little less of the wealth in the economy than before.
this theory can be explained under 3 assumptions
1- currency in circulation = Zero ( people don't keep money on hand )
2- banks keep only the required reserve
3- all deposits are checkable deposits ( no interest is paid by bank)
so in theory if every dollar borrowed was invested well and returned to the borrower from some external source (like clients to their buiseness paying them)and deposited in the bank by the borrower the banks would never have to worry about a run on the bank... because the money would pretty much all be there. is that right.
of course in reality alot of investments are very bad ones, made with borrowed money. this will always be the case. and alot of people borrow money for cars and crap.
What if the bank is the one selling the apples?
2. In that example if we keep our physical gold home it will become many times more valuable than the perceived gold in the bank (money), which implies some sort of THEFT of value is occurring with the money printing.
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What are you talking about? The borrower is borrowing it and the lender is lending it. At no point is there any "simultaneous ownership". The defintion of borrow since you seem to have yet to learn it: Take and use (something that belongs to someone else) with the intention of returning it.
@josvazg You're also not considering the percentage of risk. That was an issue that brought the recession down this 2008, that loans were irresponsable and investments wern't giving back money through morgages. The world isn't a perfect sittuation.
IDK about the whole Fed. Res. planting seeds for recessions. the only way they could do that is if they downgraded the policy to make lending much simpler. Seems a bit complicated but I suppose it's always a possibiliy, but I highly doubt it.
That's because they are deliberately inflating the currency very gradually for a good reason. Deflation is difficult to stop because it has such a huge positive feedback loop. Inflation is relatively easy to stop because you can raise rates indefinitely. But you can't lower rates past zero. And you can't borrow money to stimulate if no one will loan it to you, hence its safer to have 1 to 2% target inflation rate. It's only a loss in value if the earnings after taxes is less than inflation.
The question is how many of the loans did not generate wealth? How many were consumer loans and people spent it on new pointy shoes and vacations???
Over Unity money conversion.
Money paid for work, and more wealth was created. Wealth/Money>1 for good investments. The excess is profit for someone.
I think this only works if the investment pays off. If not that will cause a problem.
@79eXistenZ It would debase other products like oranges if the productivity capacity didn't increase, but an increasing price signals for more production and in a perfectly competitive world, the supply would increase so the purchasing power is the same again.
Actually you can eat gold. Extremely fine leaf is sometimes added to food.
Surely if you asked everyone how much money they thought they had, you'd have to include money OWED as well. AS far as I can see this would have a negative effect and would bring the value back to the same as M0,
@chrstsldr Since the real estate was overvalued, it would mean that the actual wealth goes down (I think). But there's still the same number of gold pieces. So what you end up with is inflation (same number of gold pieces, but less wealth). In the real world there are a lot more factors that come into play, but in this diagram, that's how it would probably look.
สุดยอด awesome
How does a government encourage or even force banking institutions to invest in ‘productive’ not ‘speculative’ activities?