How MONEY & BANKING Really works - Part 1 (2 of 5)

Summary

This script explores the evolution of the global monetary system from commodity-backed currencies to a debt-based system dominated by fractional reserve banking and central banks. It explains how banks create money through loans, leveraging their reserves to generate new deposits and credit, all backed by debt. The script also touches on how reserve requirements have changed over time, and how banks can multiply their reserves to create more money, highlighting the complex yet intriguing nature of modern money creation.

Takeaways

• 🏦 The fractional reserve system allows banks to create money as debt, with only a fraction of gold backing the money supply.
• 📉 The gold backing for paper money has diminished over time, transitioning from a commodity-backed currency to fiat money.
• 💼 In the past, bank credit was in the form of private banknotes, which could be refused, unlike today's legally convertible bank credit.
• 💵 Fiat currency is money created by government decree and is legally required to be accepted as payment for debt.
• 🚀 The total amount of money that can be created is now limited only by the total level of debt, not by physical commodities.
• 🏛 Fractional reserve requirements, enforced by governments, dictate how much money banks can lend relative to their reserves.
• 💰 A bank's reserves consist of government-issued cash at the central bank and existing debt money on deposit.
• 🔄 The process of money creation through loans can repeat itself, with each new deposit potentially leading to a new loan.
• 💡 Banks have an incentive to seek deposits to increase their lending capacity, which supports the misconception that loans come from deposits.
• 📉 Reserve requirements have been reduced or circumvented in recent years, allowing banks to create more money with fewer reserves.

Q & A

What is a fractional reserve system?

A fractional reserve system is a banking practice where only a fraction of the total deposits is held in reserve, and the rest is used for lending or investing. This allows banks to create new money through loans, which are essentially debt obligations.

How has the nature of money evolved over time?

Historically, money was backed by physical commodities like gold or silver. Over time, it has evolved to fiat currency, which is not backed by a physical commodity but is accepted as money because of government decree. Today, money is often created as debt through the banking system.

What is the role of central banks in the money creation process?

Central banks play a pivotal role by setting the reserve requirements for commercial banks and acting as lenders of last resort. They also influence the money supply through monetary policy tools.

What is the difference between high-powered money and bank credit?

High-powered money refers to the currency in circulation and the reserves held by banks at the central bank. Bank credit, on the other hand, is the money created by banks when they extend loans to customers, which is not backed by physical currency but by the borrower's promise to repay.

Why do banks need to maintain a reserve ratio?

Banks are required to maintain a reserve ratio to ensure they have sufficient funds to meet withdrawal demands and to maintain stability in the financial system. This ratio limits the amount of loans they can issue relative to their reserves.

How does the reserve ratio limit the amount of money a bank can create?

The reserve ratio dictates the multiple by which a bank can expand its deposits through lending. For example, a 9-to-1 ratio allows a bank to lend out nine times the amount of its reserves, creating new money in the process.

What happens when a loan is repaid in the fractional reserve system?

When a loan is repaid, the money is typically deposited back into the banking system, which can then be used to create additional loans up to the limit set by the reserve ratio, thus continuing the money creation process.

How does the fractional reserve system contribute to the total money supply?

The fractional reserve system allows banks to create new money through loans, which increases the total money supply. This process is limited by the reserve ratio and the amount of loans that are redeposited into the banking system.

What is the significance of the initial reserve deposit in the banking system?

The initial reserve deposit is crucial as it serves as the foundation for the bank's ability to create new money through loans. It is the starting point for the multiplication of money within the banking system.

How do banks incentivize deposits to increase their lending capacity?

Banks offer various incentives such as interest on deposits to attract customers. These deposits increase the bank's reserves, allowing them to lend more money and earn interest, which is a key part of their profit model.

What are the implications of banks creating money through loans?

The practice of banks creating money through loans has significant economic implications, including the potential for inflation, credit expansion, and financial instability if not managed properly. It also raises questions about the nature of money and who controls its creation.