Let’s review a little bit of
what we’ve learned about reserve banking and then we’ll
extend this to the notion of an elastic money supplier, a
money supplier that can grow or contract as people need
money– or hopefully grows and contracts as people
need money. So let me create a a couple of
normal commercial banks. Maybe I’ll call these
national banks. They have a national charter. So let’s see. I have some equity and part of
that equity– most of it is some gold that I initially
capitalized the bank with. And then some of it
is a building. Trying to draw this as neat as
possible, but I think you understand my situation. Then I take some gold deposits
from whoever– the farmers after the crop has
been harvested. And then offsetting that,
I have all of the farmers’ deposits. I’ll do that in a blue color. So that’s one farmer’s
deposit. That’s another– maybe there’s
only two farmers. And then we learned in
fractional reserve banking that I can leverage up this
amount of capital I have. There’s a certain ratio
between the amount of capital– in this case, gold or
reserves I have– and the amount of demand deposits I
can have. So let’s say my reserve requirement in this
world is– just because I don’t want this bank to become
too tall– let’s say it’s 50%. We know in reality reserve
requirements are more like 10%. Let me write that down. So that means that my ratio
of gold to demand deposit accounts cannot be any
less than 50%. So whatever this amount is, I
can double it in terms of demand deposit accounts and the
way I do that– let’s say this is collectively 100 so
I could have up to 100. Let’s say this right
here, this is 50. So I can have up to 200 in
demand deposit accounts. So I can essentially lend out
money and create demand deposit accounts. This is all review for
you, hopefully. So I could lend out 150. Those are my liabilities and
then these are my loans and my– so that’s one loan I make
out and I just create someone’s checking account. That’s the loan asset and I
create a demand deposit account for them. That’s the liability. This here could be a big
loan, et cetera. And then I’m not the only
bank in this universe. My other bank in the universe. I just want to show you that
there are multiple banks. Then we said there are a couple
of issues with this. You have a 50% reserve
requirement, which is very high, but what if there is a
situation where for whatever reason your reserves
temporarily drop below that 50%? How do you get that
extra gold? You don’t want to go to people
and say, can I have a little bit more gold? Then they’re going to get scared
and all pull out of your system, but if you’re a
little bit below 50%, but if the other bank is a little
bit above 50%, it’d be a convenient way if you could
borrow from that other bank– or even better, if there was a
central depository where all of these gold reserves were,
then you could just borrow directly from that central
depository if there were no other bank to borrow from. So you could kind of view it as
a lender of last resort and we’ll go into more of the
technicalities of that one, in particular talk about
our current system. With that said, we created a
reserve bank where we put these deposits. Let’s see. There’s 200 of deposits
in this world. Let see me if I can just
copy and paste that. So that’s one of the reserves
and then they’re the same, so then that’s the other reserve. It doesn’t look that neat. All the banks got together
and created this. It’s a private bank, but we’ll
go into more details of of how the actual Federal
Reserve works. So those are the actual
gold reserves. Those are the assets
of that bank. Actually, I should move
it over some. OK. And then the liabilities for
this central reserve bank, these are the demand deposit
accounts for these nationally chartered banks. So he took all of his gold,
put it here, and so now he has– to simplify it, he has a
demand deposit account, but I’ll assume that he just got
reserve notes to show that he had access to this gold. So let’s say that this is
100 notes outstanding. This part corresponding to 100
gold pieces– and this is another 100– although notes
outstanding, it’s fungible, you could mix them up because
you don’t know where they came from or whatever. That’s what’s different
about those relative to a checking account. And so essentially this guy
gives his gold here and in exchange he gets these Federal
Reserve notes, which are like green pieces of paper. And now these are actually
his reserves. His reserves are
no longer gold. His reserves are how much
of these Federal Reserve notes he has? And we learned in the last video
that only the Federal Reserve– or the reserve bank–
I haven’t called it the Federal Reserve yet, but I think
you see where this is going– only they can
issue these notes. And these notes are these
rectangular green pieces of paper with faces of presidents
on them, et cetera, et cetera. And let’s say in the government
we live in, they kind of sanction– even though
this is officially a private bank, this reserve bank, it’s
set up in such a way that even though all of the original banks
might have originally capitalized it with some equity,
they really don’t get any of the profits of this
bank– and I’ll go into detail on how the actual Federal
Reserve works. But let’s just say any surplus
profits of this bank actually just go back to the Federal
government. So the Federal government
doesn’t– these banks don’t make any money off of this–
and actually let’s say that the board of directors of this
bank is actually appointed by the government, et cetera,
et cetera. So it’s key to the
financial system. So the government says, these
notes, sure, it’s issued by this reserve bank, but we want
people to have a lot of faith in this currency because this is
the currency that we use in our world, in our nation, so
in order for people to have unlimited faith in this
currency, we are going to make it an obligation of the
government– so it’s issued by the bank. Let me write that down. This used to confuse
me to no end. Issued by the reserve bank, but
it’s an obligation of the government. Now, what does that mean? Well, that means that if for
whatever reason– even if this reserve bank were to somehow not
have the gold to back it up, it would go bankrupt, but
even in that situation, the government would still be
obligated to give you the gold equivalent of these notes,
whatever we decide it is. Maybe it’s 35 of these dollars
per ounce of gold or whatever. But that’s what that means. So that gives a lot of people
confidence that these things are, you can almost say,
as good as gold. Why does it matter that the
government– how can you trust the government? Well, the government can just
tax people, whether they’re going to tax them in terms of
dollars, whether they can tax them in terms of gold, whether
they can tax them in terms of goods and services. So as long as you think that
that economy– whatever the economy is that this government
is governing over– as long as you think that that
economy can somehow support the gold to back this up, you
should say, this is as good as gold– or at least support
the goods and services. Well, that said, let’s introduce
the notion of an elastic currency. Actually before I do that, let’s
go back to one thing this government does. So we said it’s an obligation
of the government, right? Which means if all else fails,
the government is going to give you the value behind
these notes. I’ll introduce you to another
concept, which is actually very similar to these notes–
and that is a government debt or government borrowing. Let me draw that down here. I think I’m going to run out of
time, but I’ll continue it in the next video. So I’m the government, right? I mean, you could almost view
the government’s asset as its ability to tax people, but if
I’m the government and I issue these government IOUs– and
we’ll call them treasury bonds and bills– let’s call them
treasuries, generally. Treasury bills are short term
treasuries where the government borrows for a
shorter amount of time. Bonds are longer term. I think I’ve gone over that in
the yield curve video, but I’ll do that in more detail. But they’re just IOUs
from the government. Now, these are going to be
considered as risk free. Why are they considered
risk free? Because they are denominated in
the same currency that the government, that the economy
that this government governs over, operates in. So if this government– and I
think you can understand that this is essentially the U.S.
government– if it borrows money from you– so it
gives you an IOU. So this is me. Let’s say this is me, this
is the government. If it gives me this IOU and I
give it $100, why do I know that this IOU is risk free? Well, because unless he starts–
the government– I’m making him masculine– but
unless they start issuing an unusual number of IOUs and just
have so much interest that they can’t sustain, you
know that they can always tax more people to get you
back your $100. So you view this thing right
here as risk free. So whenever the government goes
out there and says, hey everyone, we have a new war we
want to fight or some new type of scheme, new bureaucracy we
would like to create, we are going to borrow money from you–
someone is going to give them their currency, their
Federal Reserve notes– and in exchange, the government’s
going to give them these risk free IOUs. And then the government can use
these reserve notes to go buy goods and services or
pay soldiers or pay the bureaucrats. Now we’re going to use that
idea in the next video to learn how this Federal Reserve
bank or this reserve bank can buy and sell these government
securities in order to change the money supply. See you in the next video.