Has the printing press lost its value?

I’m hoping that right now you’re asking; “How can something that prints money not be valuable!?”  If you’re like me and you find the ridiculous paradoxes erected by us human beings in our all too regular bouts of absolute insanity, you’ll be interested in this one. What follows is a relatively brief explanation of a theory called the money multiplier, which has been explained to death on blogs already. More interesting is the analysis that follows of why it is faltering.

Fractional Reserve Banking

If a country decides to start its own currency, it can print off $1000 (it could choose any amount, but this country thinks $1000 is a nice round number) and give it to the country’s citizens, making the money supply $1000. Some citizens will put the currency in the bank and some will spend it. The money which is spent would then be in the possession of other citizens, some whom will put the money in the bank, and some who will choose to spend it. Eventually it is likely that all the money will end up being deposited in the bank. Never-the-less the money supply is still $1000, all of which is now in the bank. What happens now is that the bank keeps some fraction (lets say one tenth or ten percent) of the deposits and lends the rest out to borrowers. The people who deposited their money at the bank still believe (rightly so) they have their money, which totals $1000, but now the bank has lent $900 out to people who believe (rightly so) that they have this borrowed money. So the money supply now totals $1900. This is the magic of fractional reserve banking. If the borrowers of the bank’s money (and I use that apostrophe lightly) somehow got into financial trouble and couldn't pay back the loans, the depositors would lose their deposits (all but ten percent of them anyways). The process does not stop here though. The newly borrowed $900 is spent by the borrowers with some other citizen, who will now either put this money in the bank or spend it with someone else who might put it in the bank. Eventually all $900 of the borrowed money is likely to find its way into the bank again as deposits.

Once the bank sees these new deposits enter, it will keep ten percent of them ($90) as reserves, and lend out the remaining $810. The money supply now consists of $1900 in deposits people believe they have, plus the $1710 that borrowers believe they have. The $810 of new loans is spent and eventually finds its way back to the bank again, where ten percent of it or $81 is kept as reserves and the remaining $729 is lent out. Each time a smaller amount is lent out, resulting in a smaller amount coming back in as deposits, and a smaller amount being lent out again during the next round. Eventually the whole process peters out and the money supply will have ballooned from the original $1000 printed by the central bank to a whopping $10000. The beautiful part of the maths is, you can still just print a three percent increase in the physical notes and coins, and they will go through our fractional reserve banking process and result in a three percent increase in the money supply. It is called the multiplier model because you can derive a simple formula that spits out a number which you can multiply the monetary base by to give you the total money supply.

A lot of people realised during the GFC that when you put your money in the bank it doesn’t stay there. Banks loan out most of it so that they can charge interest. They give you a little less interest on the money you deposit with them, and the difference is their profit. Banks only keep a tiny fraction of the money deposited with them in their vaults unloaned, and this is so they have some cash on hand for the few people that actually want to withdraw some funds during the day. This is why it is called “fractional reserve banking” and the existence of this process became increasingly clear to people during the GFC as they realised that if these loans couldn’t be paid back, then the money they thought was safely at the bank would disappear. What’s more interesting than this is the recent breakdown of this multiplier mechanism and the relative helplessness this has thrust upon the central bank in its attempts to fan some inflation. That’s the topic of our next article.

Fractional Reserve Banking

Money multiplier

Loans

Deposits