 Professor Klein, Klein the younger, I guess, is the way you differentiate her. Klein the beautiful, maybe she likes to be called. She just gave her lecture on money. I wanna 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 buy a deposit from them. You exchange $100 worth of currency and they give you a slip of paper or an electronic receipt that says you now have $100 worth of deposit with them. And the bank's job is to keep your money safe for you. The other form of banking, and actually 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 asked for credit. And your bank was the institution that issued you a loan. And that way maybe your parents are also banks. I'm not sure. You probably don't trust your money with your parents. I wouldn't with mine personally. But that's what it is 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 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 says $10, you know if you hand over a $10 bill that that is sufficient to pay for it. If 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 it's on demand availability. Whenever you go into a store and you pay $10, that $10 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 out there and count up the supply of cars in the economy, you'd 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 asked 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 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 can 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 and we'll ignore some of these other items which for the most part are relatively insignificant or minor 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 of 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 the central bank, the Federal Reserve in the States, the Bank of Canada in Canada, the European Central Bank for the 18 countries that use the Euro as a currency in Europe, et cetera, et cetera. 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 go to 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 and in 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 in looking how central banks and private banks control the money supply. So first we'll start with central banking. So the Federal Reserve, that was the part where everybody was supposed to start booing. Booing. That's better. The Federal Reserve, thank you for that by the way, was created in 1913 by Active Congress and the stated purpose initially was to have an institution that would supply an elastic currency, an elastic money supply. And by elastic, the argument was that there are different needs of trade. There are different demands to use money. They ebb and flow seasonally during the year or 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 roles, its primary roles, into two different categories. One is to control the quantity or the supply of money and it does 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 and 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, it's 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 going to limit it to currency and 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 30 primary dealers. And so, the balance sheet of the Federal Reserve would change by adding $10 of new currency into the economy outstanding and it's gained $10 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's $1.7 trillion worth of US dollars outstanding. $1.7 trillion is a lot. 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 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, now I hear a drone coming in and, of course, that costs a lot of currency to buy. And, of course, foreigners also, if you go to less developed countries, it's quite 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. 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. There's 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. And, of course, those liabilities are fully backed by assets, which the Federal Reserve has bought over the years. The lion's share, almost 100% 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 $11 billion. And then there's some other assets, included in these other assets are small items. If you go to Washington, DC, which is where the central office of the Federal Reserve system is, it's a choice piece of real estate right on Constitution Ave, almost halfway between the White House and the Lincoln Memorial, you can imagine that building in the land is worth quite a bit. So that would be an example of something that's included in those other assets there. But be that as it may, the Federal Reserve has bought $3.8 trillion worth of US government bonds in the past and has issued $3.8 trillion 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 transfer 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 buys a government bond from a bank. It'll buy a billion worth of government bonds from J.P. Morgan, and then it will just electronically place $1 billion worth of money into that bank's bank account with the Fed. J.P. Morgan could also ask for currency if it wanted, but there's limits to that, right? Most people would prefer to deal with 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 or 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 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 credit or buy your credit, you would probably pay a lower interest rate than would otherwise be the fact. And since the Federal Reserve currently owns almost $4 trillion worth of US Treasury debt, which is about 25% 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 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 profit 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 Dr. Klein's lecture an optimal supply of money in the economy. At the end of the year, of course it holds a portfolio that has $4 trillion worth of bonds in it. And those $4 trillion worth of bonds pay off interest every single year. The Federal Reserve uses this interest to pay for its operating expenses, Federal Reserve, economist salaries, and keep the lights 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 billion. The year before it was approximately $82 billion, I think, of a 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 to 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, the Treasury pays zero interest for those bonds which are purchased by the Fed. And of course, there's the issue of how profitable it is to issue currency itself. So if you've got a one or a $2 note in your pocket, do you know what the cost of production is for a one or a $2 note? Yeah, it's about five cents, okay, 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 that hired the denomination of the note. But imagine that, it costs 12 cents to produce a $100 note, and then the Federal Reserve gets to purchase $100 worth of bonds which pay off interest with something that only costs 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 facilities. Now deposit banking initially emerged in the Renaissance as what we call goldsmith bankers. This is back when gold functioned 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 gold safe, and also to offer you some convenient services, and you would of course pay them for this deposit taking service. And goldsmith bankers, if you're into etymology, the science of word origins, bank derives from Latin banco, and a 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 in 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 banker. As an 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 to your goldsmith banker and say, I would like to make this deposit. Of course it wasn't a hundred dollars, it was a sum of gold. They would give you a slip of paper that says the bearer of this paper, or this person, is entitled to $100 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% 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% 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 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 at the end of the day. So full or 100% reserve banks affect the composition, but not the absolute level of the money supply. Now, it's interesting to ask yourself, and Dr. Klein touched on this briefly and I just wanna 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 incurred 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 onto it. The cost, in some sense of the word, is the foregone interest that you could earn. If you knew exactly when all your expenses would be, you wouldn't hold onto 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 gonna happen, we know when all expenditures and revenues come in their timing and their magnitude, we would never demand to hold onto money. But if we upset this balance a little bit and we introduce some real uncertainty, so you're not sure how much dinner's gonna be, you're not sure how much rent 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 onto 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 or the money holder doesn't know when they will demand to hold money, doesn't know what eventuality will cause 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 pretensive knowledge that they can estimate or forecast when you're 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% 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 anything 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 gonna go through here in a couple over the next couple of minutes, what the bank has achieved is a joining 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 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 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% reserve example the bank put all of the 100 into the vault or kept it on reserve. Now the bank's only going to keep a portion of it in reserve, in this case it's gonna be $10 or 10% 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 or $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 and buy a house but then when somebody buys that house what happens? The $90 changes hands and goes to the seller 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 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 onto 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 that that bank can then use to issue a loan. So somebody else is going to come in looking to take out a loan by a house by a car. The second bank of Auburn is going to issue the loan for $81. That person spends the $81, buys the house, the seller of the house takes the $81 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 $100 worth of cash which this person or $100 worth of currency that this person deposited in their bank. The money supply was $100. 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 account. It's vault, it's cash which the bank has put into the vault. So it's the $10 up here, which is part of the $100 of original currency. It's the $9 right here, it's the $8 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'd have to go through with the liability side of all these bank's 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 Auburn, a $90 deposit in the second bank, an $81 deposit in the third bank. The $73 loan, I'm not gonna put in the next bank, but the $73 loan which the third bank of Auburn is issuing is then going to get re-deposited 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 100 plus 90 plus 81 plus 73 plus 62, 27. And the total sum of that, if you took it to its full conclusion, would be $1,000. More on where the $1,000 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 $100 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. 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 system's ability to convert deposits into a total supply of deposits, or a total amount of new money. And I'm not gonna 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 $10 on the initial deposit of 100. The second bank kept $9 on the deposit of $90. The third bank kept $8.10 on a deposit of $81, etc., etc. So the reserve ratio was always 10%. The inverse of 10% is 10. The initial deposit was $100, $100 times 10 is $1,000, 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. 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 to change 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 $2, put it in the vault, and it would issue a loan of $98. The inverse of 2% is 50. That's the money multiplier, so if you deposited that $100, 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, you know, try to put the inverse of zero into their calculator so that you get error. Don't do that. You ever get that, Joe? 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 it issues 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 a loan 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%, the inverse of 100% is one, 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 it 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 bank's 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 in a cost to 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 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 any individual bank. Now, this analysis is thoroughly Austrian. Herbert Davenport was the originator of the analysis in 1913. All the bad students in the back, like Lucas Engelhardt, 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 and 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 in analysis. And Lidwig von Mises in 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 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 supply when a deposit is withdrawn 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 gonna 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 gonna 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 fractional reserve banking system has and 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 it 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 ex-nilo from nothing, right? All it is is a computer entry. We're gonna buy a billion dollars worth of US Treasury bonds from Bank of America. And I'm just going to, with a keystroke, debit $1 billion into their reserve account that they keep with me. Then the fractional reserve bank, so 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 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 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. It's a bank for banks. And of course, those reserves have been issued by the Fed buying government bonds from these banks in the past. And so the $1,000 worth of assets was purchased and the Federal Reserve created $1,000 worth of reserves to pay for those bonds. And then we get down to the Fractional Reserve Banking Systems Balance Sheet at the bottom. So you can see that just as there's $1,000 in reserve for this, in the central bank, there's $1,000 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 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 U.S. government bonds. So 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 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 the $1,000 worth of bonds that the Federal Reserve bought, where did they actually come from? They came from the private banking system. And so to show that effect, we need to update the Fractional Reserve Banking System's balance sheet at the bottom here. And so of course, the government bond balance goes to zero, they sell off their $1,000 worth of bonds to the Fed. The Fed gives them $1,000 worth of reserves, which means that the Fractional Reserve Banking System's 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 $2,000 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, it's 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 $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, at no cost to the central bank, $10,000 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 gonna go in and ask for your money back and make a withdrawal. And so we can comment on the Fraction Reserve banking system by noting how inherently unstable it is. If anybody comes in and requests for more than 10% 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 deposit 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 model 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 tanking 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 tanking in the banking system, also eliminate the need for costly bailouts to the banking system when there are high redemption requests and would 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 and see me during the break, okay? Thank you.