[MUSIC] This is one of my favorite modules in the whole course. It's because it tells a really interesting story about how the rudiments of the modern money and banking system, along with paper money, were first created long ago. For me to tell this story we have to go back hundreds of years to merry old England, when commodity money, such as gold, was the prevailing medium of exchange and goldsmiths would emerge as the world's first commercial bank. In this earlier era people, didn't like to carry around all of their gold or leave it sitting around the house, because it was cumbersome and it might even get stolen. So, people asked their goldsmith to store it. Now, the goldsmiths in turn would give the gold depositors a paper receipt. And when the depositor needed to get some gold to make a purchase, he or she would use that receipt to redeem the gold. Now, over time three important things happen that help create paper money and the banking system. You think what these things might be? Take a minute to ponder this question and jot down some thoughts before moving on. [MUSIC] Now the first thing that the gold depositors figured out is that they didn't have to necessarily schlep back to the goldsmiths, redeem their gold receipts every time they wanted to buy something. [MUSIC] Instead, they could trade their gold receipts for goods. In effect, these receipts functioned as the first paper money. But that's not the only thing that happened. [MUSIC] Second, the gold depositors also figured out that they didn't have to leave their gold with the goldsmith for free. In fact, wasn't long before goldsmiths began competing for depositors' gold. In those good old days, these goldsmiths didn't offer people free toasters or rebates to open an account to receive bags during the day. But the goldsmiths did begin to offer depositors interest on their gold deposits and this became the precursor to interest bearing bank and savings accounts. [MUSIC] Now here may be the most interesting and important aspect of the goldsmith's story. The goldsmiths, themselves, figured out that they can under what is today called the system of fractional reserves. For example, a goldsmith might take in $1,000 of gold deposits from one depositor and issue a receipt for that amount. At the same time, that same goldsmith might turn around and issue additional $1,000 in gold receipts as an interest bearing loan to another person. And note that the goldsmiths would do that because even though the goldsmith knew full well that he or she didn't have enough gold deposits to redeem all the receipts that he or she issued. They thought they could do it. Of course this was a bit risky, but the goldsmiths figured out they could operate this way because it was highly unlikely that everyone who held their gold receipts would come in at the same time to demand their gold. And in this way, the system of fractional reserves, fractional reserves was born. And you can see how such a system of fractional reserves greatly adds to the money supply. For example, suppose the goldsmiths as a group Issued $2 of gold receipts for every $1 of gold they received. What's the fractional reserve in this case? Do you see how this system of fractional reserves helps create money? Please jot down your answer now before moving on. [MUSIC] Well, in this case, the implicit fractional reserve is 50% and with twice as many gold receipts floating around as there is gold in the vaults at any one time, you can see how the money supply effectively double. In fact, today's modern banks function much like the goldsmiths of old. And let's use an example now to show you how the banking system actually helps to create money. [MUSIC] Suppose for example that a person deposits $1,000 in bank one. This table shows the balance sheet for bank 1 in this initial position, where both reserves and deposits are $1,000. Now suppose further that the bank's board of directors decides that they're going to maintain a fractional reserve requirement of 10%. This means that the board of directors is betting that no more than 10% of their depositors will come in and demand their money at any one time. Now, this 10% fractional reserve in turn means that the bank can safely lend out at least $900 of the new $1,000 demand deposit. This table shows bank 1's balance sheet after making such a move. Deposits remains at $1,000. Our reserves falls to $100 while our loans and investments go to $900. At this point, the borrower from bank 1 when deposits the money in bank 2 and this is reflected in bank 2's initial balance sheet in this table. However, since bank 2 also has a 10% reserve requirement, it can lend out funds, $810 to be precise, and this is indicated by bank 2's final balance sheet in this table. Of course, by now you get the picture. And $810 is deposited in bank three. Bank three lends out $729. Bank four lends out $656 and so on. And from this table, you can see how the actions of all the banks together produce what is called the multiple expansion of money. The final equilibrium is reached when every new dollar of original bank reserves supports $10 of demand deposits. Through this expansion, your original $1,000 demand deposit creates an additional $9,000 of new loans and investments and a total of $10,000 in new deposits. [MUSIC] So here's a question for you, from this example, can you figure out more formally how to calculate an actual money multiplier that describes the relationship between any given reserve requirement and the rate of money creation? Take a minute to think about this. And maybe jot down your own formula before moving on to the next module for an answer. [MUSIC]
