ECO LECTURE 33 1 WHAT WE WANT TO DO TODAY IS WE WANT TO CONTINUE WITH THAT MATERIAL THAT WE HAD LAST TIME WHEN WE TALKED ABOUT THE ORIGIN OF

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1 ECO LECTURE 33 1 WHAT WE WANT TO DO TODAY IS WE WANT TO CONTINUE WITH THAT MATERIAL THAT WE HAD LAST TIME WHEN WE TALKED ABOUT THE ORIGIN OF DIFFERENT KINDS OF MONEY AND HOW IT'S EVOLVED OVER THE YEARS. AS I MENTIONED TO YOU LAST TIME, MONEY WAS NOT ORIGINALLY INVENTED BY GOVERNMENT BUT CERTAINLY GOVERNMENTS CONTROL MONEY IN OUR MODERN WORLD TODAY. IN THE UNITED STATES TODAY, WE'VE GOT REALLY TWO MAIN KINDS OF MONEY, WHAT WE CALL MONEY. AND, IF YOU REMEMBER, FOR IT TO BE MONEY IT HAS TO BE A UNIT OF ACCOUNT AND IT HAS TO BE A MEDIUM OF EXCHANGE. AND SO WE'VE GOT A COUPLE OF THINGS THAT SERVE AS MONEY IN THE UNITED STATES TODAY. THE ONE KIND IS CURRENCY, WHICH I'LL JUST USE THIS CAPITAL C TO REPRESENT CURRENCY. BUT THERE'S CURRENCY -- I MEAN BY THIS TERM "CURRENCY" BOTH COINS AND PAPER NOTES. SO LIKE A TEN DOLLAR BILL, THAT'D BE CURRENCY BUT SO WOULD A TWENTY-FIVE CENT PIECE. OKAY. THAT'S ONE FORM OF CURRENCY. AND, YOU KNOW, THERE'S NOT A BIG MYSTERY WHERE THAT COMES FROM, IS THERE? WE KNOW -- OR I ASSUME YOU KNOW WHERE IT COMES FROM. THE TREASURY DEPARTMENT HAS A MINT THAT STAMPS OUT COINS. IT'S GOT A BUREAU OF ENGRAVING AND PRINTING THAT STAMPS OUT THE PAPER NOTES. SO IT'S REALLY THE TREASURY DEPARTMENT THAT MANUFACTURES CURRENCY IN THE UNITED STATES. THERE'S ANOTHER FORM OF MONEY WHICH IS CHECKING DEPOSITS AT

2 ECO LECTURE AND I'LL HAVE A LITTLE LIST HERE -- COMMERCIAL BANKS WHICH WE NORMALLY JUST CALL BANKS; AT SAVINGS AND LOANS; AT MUTUAL SAVINGS BANKS; AND AT -- AND I'LL JUST ABBREVIATE THAT MSV. THAT'S THE STUFF THE CHINESE PUT IN THEIR FOOD THAT SOMETIMES, YOU KNOW, GIVES YOU TROUBLE. AND FINALLY, AT CREDIT UNIONS. OKAY. AND SO ANYWAY, CHECKING DEPOSITS AT THESE -- THEY'D JUST CALL THESE DEPOSITORY INSTITUTIONS. BY THE WAY, THERE'S ONE MORE THING THAT TECHNICALLY CALLED MONEY IN THE UNITED STATES AND I HAVEN'T INCLUDED IT UP HERE. AND THE REASON FOR THAT, IT'S REALLY JUST TOO SMALL IN TERMS OF ITS MAGNITUDE TO PAY MUCH ATTENTION TO. BUT THE OTHER THING IS TRAVELERS' CHECKS. THERE'S ABOUT EIGHT BILLION DOLLARS WORTH OF TRAVELERS' CHECKS IN THE UNITED STATES AND YOU'D SAY, "WELL, EIGHT BILLION DOLLARS IS A LOT." AND IT IS A LOT FROM THE PERSPECTIVE OF AN INDIVIDUAL OR EVEN FROM SPRINGFIELD'S POINT OF VIEW. BUT EIGHT BILLION DOLLARS IS DWARFED BY THE AMOUNTS THAT ARE IN THESE TWO DIFFERENT CATEGORIES. WITH THE AMOUNT OF CURRENCY, WE'RE TALKING WAY OVER FOUR HUNDRED BILLION DOLLARS AND WITH THE AMOUNT OF CHECKING DEPOSITS, WE'RE TALKING OF BETWEEN SIX AND SEVEN HUNDRED BILLION DOLLARS. AND SO WE'RE TALKING HUNDREDS OF BILLIONS OF DOLLARS WITH THESE TWO, AND I'M SAYING TRAVELERS' CHECKS -- EIGHT BILLION DOLLARS. SO WE KIND OF LEAVE THAT OUT USUALLY.

3 ECO LECTURE 33 3 LET ME INTRODUCE A TERM. IT'S THE M-1 MONEY SUPPLY. M-1. THIS IS NOT AN M-I OR AN M-L, BUT AN M-1 MONEY SUPPLY. OFTENTIMES I JUST PUT THAT LITTLE DASH IN THERE BUT SOMETIMES YOU SEE IT WITHOUT IT. BUT THE M-1 MONEY SUPPLY IS EQUAL TO JUST WHAT WE'VE WRITTEN HERE: CURRENCY PLUS CHECKING DEPOSITS. I'M GONNA USE -- I'M NOT JUST GONNA SPELL IT OUT. I'LL PUT DD. AND THE REASON FOR THAT DD -- WE'LL CALL THAT DEMAND DEPOSITS. AND THIS IS REALLY KIND OF A SHORTHAND NOTATION FOR ALL THESE CHECKING DEPOSITS, BUT THE IDEA IS THE MONEY IS AVAILABLE ON DEMAND. IF YOU PUT MONEY IN YOUR CHECKING ACCOUNT AT THE BANK, YOU PUT A THOUSAND DOLLARS IN THE BANK AND GO BACK NEXT WEDNESDAY AT FOUR O'CLOCK, THAT MONEY IS PAYABLE ON DEMAND. YOU WALK INTO THE BANK, SAY, "I WANT THAT THOUSAND DOLLARS OUT OF MY CHECKING ACCOUNT," AND THEY'RE SUPPOSED TO SAY, "OKAY," AND GIVE IT TO YOU. IT'S ON DEMAND. THERE'S TIME DEPOSITS OR A SAVINGS ACCOUNT AND THAT'S WHERE YOU PUT THE MONEY IN AND YOU PLEDGE TO LEAVE IT A CERTAIN AMOUNT OF TIME. BUT I'M SAYING THAT WHEN YOU PUT MONEY IN A CHECKING ACCOUNT AT ONE OF THESE DEPOSITORY INSTITUTIONS, THE UNDERSTANDING YOU HAVE WITH THEM AND WHAT THE LAW SAYS IS THAT THEY GIVE THE MONEY BACK WHEN YOU WANT IT BACK. AND, OF COURSE, YOU CAN ALSO WRITE A CHECK, AN ORDER TO THEM, TO PAY SOMEBODY ELSE. BUT ANYWAY -- NOW, BY THE WAY, DEMAND DEPOSITS STRICTLY

4 ECO LECTURE 33 4 SPEAKING ARE REALLY ONLY THE ACCOUNTS AT BANKS, COMMERCIAL BANKS. AND THEY HAVE DIFFERENT NAMES FOR THE CHECKING ACCOUNTS AT THESE OTHER INSTITUTIONS. SO THAT'S WHAT I'M TELLING YOU IS, I'M SORT OF, I GUESS, NOT BEING QUITE AS PRECISE AS I COULD BE. BUT THIS PRECISION IN THIS PARTICULAR CASE, WE DON'T NEED. IT DOESN'T HELP US UNDERSTAND THE ECONOMY BETTER OR THE BANKING SYSTEM. BUT TECHNICALLY SPEAKING, THERE'S ONLY DEMAND DEPOSITS, THE THING WE CALL DEMAND DEPOSITS, AT A COMMERCIAL BANK. AND THEN THESE OTHER INSTITUTIONS HAVE THEIR OWN. THEY'RE CALLED NOW ACCOUNTS. NOW ACCOUNTS AND THEN SHARE DRAFT ACCOUNTS, WHICH I WON'T ASK YOU THAT ON AN EXAM. I JUST WANT YOU TO BE FAMILIAR WITH THE FACT THAT I AM -- BY USING THIS TERM "DEMAND DEPOSIT," I'M SORT OF TAKING SOME LIBERTIES. BUT ANYWAY, THE IDEA IS THERE WITH THE DEMAND DEPOSIT THAT THE MONEY IS PAYABLE UPON DEMAND. OKAY. SO ANYWAY, MOST MONEY IN THE UNITED STATES IS THIS KIND OF MONEY, THIS CHECKING ACCOUNT KIND OF MONEY. TODAY THE M-1 MONEY SUPPLY IS ABOUT ONE THOUSAND, ONE HUNDRED BILLION DOLLARS. OR ANOTHER WAY OF SAYING THAT IS ONE POINT ONE TRILLION. OKAY. AND OUT OF THAT THERE'S ABOUT FOUR HUNDRED AND FIFTY BILLION DOLLARS THAT'S CURRENCY AND ABOUT SIX HUNDRED AND FIFTY BILLION DOLLARS THAT'S CHECKING DEPOSITS. AND SO THE MAJORITY OF WHAT PASSES FOR MONEY IN THE UNITED STATES, THE STUFF THAT'S GENERALLY ACCEPTABLE IN PAYMENT FOR GOODS AND SERVICES -- AND THAT'S REALLY WHAT MONEY

5 ECO LECTURE 33 5 IS. IT'S WHATEVER CAN BE SPENT. SO WHATEVER IS GENERALLY ACCEPTED IN PAYMENT FOR GOODS AND SERVICES, WE CALL IT MONEY AND THAT'S THESE THINGS: CURRENCY, CHECKING DEPOSITS AND TRAVELERS' CHECKS WHICH WE'RE LEAVING OUT. OKAY. AND I'M SAYING THAT WELL OVER HALF OF THE TOTAL IS THE CHECKING ACCOUNT KIND OF MONEY. SO REALLY WHAT WE WANT TO UNDERSTAND IS THIS. AND, BY THE WAY, BEFORE I GO ON, THIS IS A LOT OF MONEY. IF YOU DIVIDE IT OUT BY THE NUMBER OF PEOPLE IN THE UNITED STATES, THIS IS ABOUT FORTY-ONE HUNDRED DOLLARS PER U.S. RESIDENT. I WAS CHECKING MY POCKETS THIS MORNING BEFORE I CAME TO WORK AND HAD A LITTLE BIT LESS THAN THAT FORTY-ONE HUNDRED DOLLARS IN MY POCKET. ON THE OTHER HAND, THIS FORTY-ONE HUNDRED DOLLARS, YOU SHOULDN'T NECESSARILY EXPECT TO SEE A LOT OF PEOPLE WITH FORTY-ONE HUNDRED DOLLARS. THIS IS A SIMPLE CALCULATION. IT JUST TAKES THE TOTAL AMOUNT OF MONEY SUPPLY OUTSTANDING AND THEN DIVIDES BY THE POPULATION OF THE UNITED STATES. WHAT IS IT, TWO HUNDRED AND SEVENTY MILLION OR SOMETHING LIKE THAT. AND SO THAT'S WHERE THIS NUMBER COMES FROM. AS A MATTER OF FACT, ALL OF THIS MONEY IS NOT HELD IN THE UNITED STATES. SOME OF THIS MONEY IS HELD OVERSEAS. SOME IS OVERSEAS. AND SO IF THAT'S THE CASE -- AND THAT IS THE CASE. I HEARD THE FEDERAL RESERVE -- A COUPLE OF FEDERAL RESERVE OFFICIALS TALKING ABOUT THIS YESTERDAY ON TELEVISION, ON C-SPAN. BUT SINCE A LOT OF THIS IS HELD OVERSEAS, MAYBE IT DOESN'T MEAN MUCH TO BE DIVIDING BY THE

6 ECO LECTURE 33 6 UNITED STATES POPULATION. YOU MAY NOT KNOW ABOUT THIS BUT THE TOPIC ON TELEVISION YESTERDAY WITH THE FED OFFICIALS TALKING WAS DOLLARIZATION. THEY WERE TALKING ABOUT A GROWING NUMBER OF COUNTRIES OVERSEAS THAT WERE USING THE DOLLAR AS THEIR CURRENCY. PANAMA IS ONE EXAMPLE. OVER THE YEARS, PANAMA HAS NOT HAD -- AND I DON'T MEAN EVER IN HISTORY. BUT IN RECENT YEARS, PANAMA DOESN'T HAVE ITS OWN CURRENCY. IT USES THE UNITED STATES DOLLAR AS ITS LEGAL TENDER. AND SO THE POINT IS IS THAT AS COUNTRIES DO THIS -- AND THERE ARE MORE COUNTRIES THAT DO IT AROUND THE WORLD AND IT'S A GROWING NUMBER IN RECENT YEARS. BUT AS COUNTRIES DO THIS, THEN THE WORLD -- THE TOTAL MONEY SUPPLY IS A LARGE NUMBER BUT NOT ALL OF IT'S IN THE UNITED STATES. SO THEN IF IT'S NOT ALL IN THE UNITED STATES, WE SHOULDN'T EXPECT FOR EACH AMERICAN TO HAVE ON AVERAGE FORTY-ONE HUNDRED DOLLARS. AND ALSO A THING I'D MENTION TO YOU IS YOUR SHARE OF THAT MONEY -- LET'S SAY YOU OWN SOME SHARES OF STOCK IN GENERAL MOTORS. AND IF GENERAL MOTORS HAD TEN MILLION DOLLARS IN ITS CHECKING ACCOUNT, THEN YOU WOULD ACTUALLY OWN A LITTLE BIT OF THAT TEN MILLION DOLLARS. SO SOME OF YOUR FORTY-ONE HUNDRED DOLLARS MIGHT BE THERE. IT'S NOT YOUR FORTY-ONE HUNDRED BUT THE PER CAPITA FIGURE. SO ANYWAY, HERE'S WHAT'S GOING ON. THE DOLLAR IS USED

7 ECO LECTURE 33 7 OVERSEAS. SOMETIMES -- AND I GAVE YOU THE EXAMPLE OF PANAMA AND THERE WERE A COUPLE OF OTHER SOUTH AMERICAN COUNTRIES THAT ARE RIGHT NOW CONSIDERING ADOPTING THE DOLLAR, I THINK. MAYBE ARGENTINA, IF I'M NOT MISTAKEN. BUT POSSIBLY I AM MISTAKEN ON THAT. BUT ANYWAY, SOME COUNTRIES ARE CONSIDERING USING IT. THEN THEY WOULD USE THE DOLLAR AS THEIR UNIT OF ACCOUNT TO KEEP TRACK OF THAT USE AND AS THEIR MEDIUM OF EXCHANGE TO BUY THINGS. IN SOME COUNTRIES LIKE RUSSIA, THEY STILL USE -- AND I THINK I'VE ALREADY MENTIONED THIS. THEY STILL USE THEIR OWN CURRENCY AS THE MEDIUM OF EXCHANGE, SPENDING MONEY, AND AS THE UNIT OF ACCOUNT TO KEEP TRACK OF VALUES, BUT THEY USE THE DOLLAR AS THEIR STORE OF VALUE. AND THE REASON THEY DO THAT IS THAT THEY HAVE INFLATION IN THEIR OWN CURRENCY AND IT'S DRIVING DOWN THE VALUE OF THAT CURRENCY. PEOPLE DON'T WANT TO STORE THEIR WEALTH BY HOLDING THEIR HOME CURRENCY. THEY WANT TO HOLD OTHERS. SO THERE'S DIFFERENT THINGS GOING ON AROUND THE WORLD AND THERE'S A LOT OF OUR MONEY OVERSEAS, ESPECIALLY THE CURRENCY COMPONENT. LET'S GO BACK TO THIS. OUT OF THAT TOTAL M-1 MONEY SUPPLY, THE PART THAT'S OVERSEAS, MOST OF THE OVERSEAS STUFF IS CURRENCY. OKAY. AND NOT A WHOLE LOT IN CHECKING DEPOSITS. NOT A LOT OF PEOPLE FROM RUSSIA COME TO THE UNITED STATES, ESTABLISH A CHECKING ACCOUNT, AND THEN, YOU KNOW, GO BACK TO RUSSIA AND JUST KIND OF MIND THEIR OWN BUSINESS. THEY'LL KEEP THEIR ACCOUNTS AND

8 ECO LECTURE 33 8 SO FORTH IN RUSSIA IF THERE'S A CHECKING ACCOUNT. BUT IF THEY WANT TO HOLD U.S. DOLLARS, THEY'LL HOLD CASH. THERE'S ABOUT -- I WROTE THIS NUMBER DOWN SOMEPLACE. HERE IT IS. FOUR HUNDRED AND FIFTY BILLION DOLLARS WORTH OF CURRENCY. OUT OF THIS FOUR HUNDRED AND FIFTY BILLION DOLLARS, OVER HALF -- YOU CAN BELIEVE THIS OR NOT. OVER HALF OF THAT FOUR HUNDRED AND FIFTY BILLION IS OUT OF THE UNITED STATES. I'M GONNA SAY ABOUT. NOBODY KNOWS THE EXACT NUMBER BECAUSE IT'S HARD TO SURVEY PEOPLE AROUND THE WORLD. BUT OVER HALF OF THAT -- I'M GONNA SAY TWO HUNDRED AND FIFTY BILLION DOLLARS IS OVERSEAS, AND SO THERE'S ONLY REALLY ABOUT TWO HUNDRED BILLION DOLLARS IN THE UNITED STATES. SO ANYWAY, IT'S HARD TO KNOW ABOUT THIS STUFF. BUT WHAT WE DO KNOW IS THIS: OUT OF THE WORLD TOTAL M-1 MONEY SUPPLY OF THE U.S. DOLLARS AND SO FORTH, ABOUT SIXTY PERCENT IS THIS CHECKING ACCOUNT MONEY AND ONLY ABOUT FORTY PERCENT IS CURRENCY. HERE'S WHAT WE WANT TO UNDERSTAND. THIS IS EASY. WHERE DOES THE CURRENCY COME FROM? I TOLD YOU A MOMENT AGO THAT CURRENCY COMES FROM THE TREASURY DEPARTMENT IN WASHINGTON. BUREAU OF ENGRAVING AND PRINTING MAKES THE PAPER NOTES AND THAT'S A SPECIAL KIND OF PAPER WITH LINEN AND COTTON IN IT, SO IT'S NOT JUST LIKE THE PAPER, YOU KNOW, YOU'RE WRITING ON, TAKING NOTES ON. BUT ANYWAY, BUREAU OF ENGRAVING AND PRINTING PRINTS THAT AND THE BUREAU AT THE MINT PRINTS THE COINS, SO THERE'S NO MYSTERY WHERE THAT STUFF

9 ECO LECTURE 33 9 COMES FROM. SO I'M SAYING THE FORTY PERCENT OF THE MONEY SUPPLY THAT IS CURRENCY, I KNOW WHERE THAT CAME FROM AND I DON'T NEED TO TEACH A CLASS ON THAT. HERE'S THE STUFF THAT WE WANT TO TALK ABOUT IS THE OTHER SIXTY PERCENT. WHERE DO ALL THOSE CHECKING ACCOUNTS COME FROM? NOW, IF YOU THINK ABOUT IT FOR JUST A SECOND, WHERE DO YOU GET THE MONEY THAT'S IN YOUR CHECKING ACCOUNT? MAYBE YOU GOT A PAYCHECK FROM SOMEBODY. YOU KNOW, YOU WENT TO YOUR JOB, YOU WORKED, THEY GAVE YOU A CHECK, YOU WENT AND DEPOSITED IT IN YOUR ACCOUNT, AND NOW YOU'VE GOT MONEY IN YOUR ACCOUNT. YEAH, BUT THEY GIVE YOU A CHECK AND SO THERE WAS ALREADY SOME CHECKING ACCOUNT MONEY. WHERE'D THAT COME FROM? THERE IS KIND OF A MYSTERY ABOUT THIS. THIS IS KIND OF A DIFFICULT THING. I MEAN, IF YOU'RE JUST KIND OF SITTING AROUND, THINKING ABOUT IT, AND I DON'T THINK THE ANSWERS ARE GONNA COME TO YOU. WHAT I WANT TO DO IS I WANT TO TALK WITH YOU ABOUT THIS PROCESS BY WHICH CHECKING ACCOUNT MONEY IS CREATED. AND THAT'S KIND OF THE MYSTERY STUFF AND SO WE WANT TO TALK ABOUT THAT. BEFORE WE GET STARTED, LET'S DEFINE SOME TERMS. AND IT'LL TAKE US A FEW MINUTES TO DO THIS, BUT THE FIRST ONE -- AND WE'RE TALKING ABOUT BANKING. LET ME COME BACK JUST TO MAKE THIS OBVIOUS IF IT ISN'T ALREADY TO YOU. THIS IS CHECKING ACCOUNT MONEY, ITS DEPOSITS AT BANKS AND OTHER DEPOSITORY INSTITUTIONS. OKAY. SO WHAT WE NEED

10 ECO LECTURE TO TALK ABOUT IS BANKING. THE BANKS ARE THE KEY TO UNDERSTANDING THIS. AND SO REALLY WHAT WE'RE GONNA PUT HERE IS SOME BANKING CONCEPTS AS WELL AS JUST ECONOMIC CONCEPTS. HERE'S ONE: TOTAL RESERVES OF BANKS. TR, TOTAL RESERVES. THIS IS A DOLLAR AMOUNT. OKAY. THOSE RESERVES ARE DOLLARS, WHAT, VAULT CASH PLUS DEPOSITS AT THE FEDERAL RESERVE. NOW, WE HAVEN'T GOTTEN TO THAT YET. WE'LL TALK ABOUT IT MORE LATER ON. BUT THE FEDERAL RESERVE IS THE FED. I'VE USED THAT TERM A FEW TIMES THIS SEMESTER BUT NOW WE'RE GETTING INTO THAT SECTION OF THE COURSE WHERE WE'RE GONNA TALK ABOUT BANKING AND MONETARY POLICY, AND IT'S THE FED IS THE FEDERAL RESERVE. I'LL COME BACK AND GIVE YOU MORE DETAILS ABOUT IT LATER ON. BUT ANYWAY, WHAT ARE OUR BANKS' RESERVES? THESE -- YOU KNOW, BANKS HOLD RESERVES AND FOR SURE ALL BANKERS KNOW THIS TERM. IF YOU HAVEN'T HEARD IT, THEN MAYBE YOU'LL LEARN SOMETHING HERE. BUT WHERE ARE THOSE RESERVES? IT'S JUST ALL THE DOLLARS THAT ARE IN THESE TWO PLACES. IF A BANK HAS DOLLARS IN THE VAULT -- THAT IS TO SAY ON THE PREMISES, CASH DRAWER, OR SOMEPLACE LIKE THAT -- WE WOULD SAY THAT'S PART OF THE BANK'S RESERVES. IF THEY HAD THE DOLLARS AT THE FED IN AN ACCOUNT -- THE FED WON'T DO BUSINESS WITH US DIRECTLY AND WE CAN'T PUT DEPOSITS THERE, BUT BANKERS PUT THEIR DEPOSITS AT THE FED AND THAT'S THEIR RESERVE DEPOSITS. YOU PUT MONEY IN THE BANK AND THE BANKS REQUIRE YOU TO

11 ECO LECTURE HOLD A RESERVE, AND THEY'LL PUT IT IN ONE OF THOSE PLACES. HERE'S A SECOND TERM: THE REQUIRED RESERVE RATIO. AND I'M GONNA USE A LOWER CASE R TO REPRESENT THE REQUIRED RESERVE RATIO. THIS IS SET BY THE FED AND, TO GIVE YOU AN EXAMPLE, IT MIGHT BE TEN PERCENT OR IN DECIMALS POINT ONE ZERO. AND, BY THE WAY, THAT'S WHAT THE REQUIRED RESERVE RATIO IS IN THE UNITED STATES, IS TEN PERCENT. THAT'S FOR A MEDIUM SIZED BANK OR A BIG BANK. SMALLER BANKS GET A BREAK AND IT'S A LITTLE BIT LOWER. BUT WHAT I'M SAYING TO YOU IS THIS: IF YOU GO TO A BANK TODAY, AN AVERAGE SIZED BANK, AND YOU WALK IN AND YOU SAY, "HERE. I WANT TO DEPOSIT THIS" AND YOU GIVE 'EM, LET'S SAY, A HUNDRED DOLLARS IN CASH. "I WANT TO PUT THIS IN MY ACCOUNT." THAT BANKER WOULD SAY, "OKAY" AND HERE COMES A HUNDRED DOLLARS. AND WHEN THAT HUNDRED DOLLARS CROSSES THE COUNTER AND GOES INTO THE CASH DRAWER, THAT'S VAULT CASH, NOW THAT BANKER'S RESERVES HAVE GONE UP. OKAY. BUT NOW THE BANKER SAYS, "OH, MY RESERVES WENT UP BY A HUNDRED DOLLARS THAT I PUT IN THE DRAWER," AND THE BANKER THEN SAYS, "I'VE GOTTA HOLD ON RESERVE -- MUST HOLD, BY LAW -- TEN PERCENT OF THAT, TEN DOLLARS. I HAVE TO PUT TEN DOLLARS IN THE DRAWER BUT I PUT A HUNDRED IN. SO NINETY DOLLARS I DIDN'T HAVE TO PUT IN. THAT'S EXCESS RESERVES." SO ANYWAY, HERE'S THE TOTAL AMOUNT OF REQUIRED RESERVES, OR R EQUALS R TIMES DD. AND SO WHAT WE'RE WORKING WITH HERE IS THIS

12 ECO LECTURE REQUIRED RESERVE RATIO, LIKE POINT ONE ZERO, TEN PERCENT, TIMES THE TOTAL AMOUNT IN CHECKING DEPOSITS AT THE BANKS. OKAY. AND LET'S SAY THAT A BANK WAS HOLDING ONE MILLION DOLLARS IN CHECKING DEPOSITS OF CUSTOMERS. THEN THE BANK WOULD SAY, "WELL, WE'VE GOT A WHOLE TEN PERCENT OF A MILLION. WE'VE GOTTA HOLD TEN PERCENT OF A MILLION. WE'VE GOTTA HOLD A HUNDRED THOUSAND DOLLARS ON RESERVE." SO IT'S REQUIRED RESERVES, CAPITAL OR -- BY THE WAY, I HAVEN'T REALLY MENTIONED IT BEFORE, BUT ANYTIME YOU SEE ME WRITE DOWN THESE CAPITAL LETTERS LIKE TR, RR, WE'RE TALKING WITH THE CAPITAL LETTERS, THOSE ARE DOLLAR AMOUNTS. AND WHEN I WRITE DOWN THIS LOWER CASE LETTERS, THEN THOSE ARE RATIOS OR A PERCENT OR SOMETHING LIKE THAT. OKAY. SO THE WAY I TOLD THE STORY JUST A MOMENT AGO, YOU WALK INTO THE BANK, YOU MAKE A DEPOSIT OF A HUNDRED DOLLARS, THE BANK SAYS, "I'VE GOTTA HOLD TEN PERCENT TIMES ONE HUNDRED DOLLARS. MY REQUIRED RESERVES ARE TEN DOLLARS." OKAY. NEXT TERM: EXCESS RESERVES. AGAIN, A CAPITAL LETTER, ER, SO THAT'S A DOLLAR AMOUNT THAT'S EQUAL TO TOTAL RESERVES MINUS REQUIRED RESERVES. YOU COME TO THE BANK, YOU PUT A HUNDRED DOLLARS IN THE BANK IN A DEPOSIT. THEIR TOTAL RESERVES GO UP BY A HUNDRED DOLLARS BUT THEIR REQUIRED RESERVES ONLY WENT UP BY TEN DOLLARS -- WE JUST DID THE CALCULATION -- SO THEIR EXCESS RESERVES

13 ECO LECTURE ARE NINETY DOLLARS. NOW, FROM THE POINT OF VIEW OF BANKERS -- NOT FROM THE POINT OF VIEW OF EVERYBODY IN SOCIETY, BUT FROM THE POINT OF VIEW OF BANKERS, THESE ARE BAD. THESE ARE REAL BAD. THIS IS ABOUT THE WORST THING YOU CAN HAVE IF YOU'RE A BANKER. WHY IS IT? AND THE ANSWER IS: BECAUSE THIS IS MONEY JUST SETTING IN THE VAULT OR SETTING AT THE FED, JUST SETTING THERE DOING NOTHING. AND YOU KNOW WHAT BANKERS LIKE THEIR MONEY TO DO. THEY LIKE THAT MONEY TO WORK. THEY LIKE TO SAY, "GET OUT THERE, SON, AND DO SOMETHING FOR ME." AND SO WHAT THAT BANKER WILL DO IS, IF THERE'S NINETY DOLLARS IN THIS PARTICULAR CASE SETTING IN THE VAULT -- IT DOESN'T HAVE TO BE THERE, EARNING NO INTEREST, JUST TAKING A NAP, YOU KNOW, LIKE SUMMER VACATION -- THEN WHAT WILL HAPPEN IS THAT BANKER WILL SAY, "MAN, I HATE THAT. I'M GONNA GET THAT NINETY DOLLARS OUT AND PUT IT TO WORK." AND SO THAT BANKER WILL MAKE A LOAN, MAKE A GOOD LOAN. LOAN EXCESS RESERVES. WHY? FOR INTEREST. WHO CARES ABOUT INTEREST? AND THE ANSWER IS: THE OWNERS OF THE BANK. THEY WANT PROFITS. QUESTIONS ABOUT ANY OF THIS? OKAY. GOT A FEW MORE TERMS AND THESE ADDITIONAL TERMS THAT I'M GONNA PUT UP ARE ACCOUNTING TYPE TERMS, THINGS THAT YOU WOULD LEARN IN AN ACCOUNTING CLASS. ON THE OTHER HAND, THESE AREN'T VERY COMPLICATED. MOST EVERYBODY CAN CATCH ON TO 'EM.

14 ECO LECTURE ASSETS. ASSETS ARE THINGS POSSESSED BY, OWNED BY -- IT COULD BE A COMPANY, IT COULD BE AN INDIVIDUAL, BUT IT'S JUST SOMETHING THAT PEOPLE OR COMPANIES, ORGANIZATIONS OWN. OKAY. AND WHAT WE DO IS WE USE THE DOLLAR VALUE OF THOSE ASSETS AND WE USE OUR UNIT OF ACCOUNT TO TRACK WHAT ARE THOSE ASSETS WORTH. FOR EXAMPLE, IF YOU TOOK MY CAR AND MY HOUSE AND MY CLOTHES AND MY COMPUTER, AND EVERYTHING LIKE THAT, AND YOU WENT OUT AND SOLD IT ALL. THEN YOU WOULD HAVE, WHAT, TEN THOUSAND DOLLARS. THAT'S IF IT WAS A GOOD DAY AND PEOPLE WERE FEELING GENEROUS TOWARD ME. OKAY. ANOTHER TERM: LIABILITIES. LIABILITIES. WHAT DO YOU OWE SOMEBODY ELSE? ALSO MY DAD'S SENSE OF HUMOR IS ONE OF MY LIABILITIES. BUT WHAT DO YOU OWE OTHERS -- AND AGAIN, IN DOLLAR AMOUNTS? LET'S SAY IF YOU FOUND OUT HOW MUCH I OWE EVERYBODY ELSE AND PAID 'EM ALL OFF, THEN I WOULD HAVE TO PAY THEM LIKE EIGHTY THOUSAND DOLLARS. SO MY ASSETS ARE FAR SMALLER THAN MY LIABILITIES. ANYWAY, I'M JUST KIDDING ABOUT WHAT MY ASSETS AND LIABILITIES ARE WORTH. BUT THE POINT IS IS THAT LIABILITIES, WHAT WE OWE OTHERS. THE DIFFERENCE BETWEEN THESE TWO IS NET WORTH OR CAPITAL -- THESE ARE DIFFERENT TERMS -- OR WEALTH. IT DEPENDS REALLY ON WHO YOU'RE DOING THE ACCOUNTING FOR AS TO WHAT TERM YOU USE IN THIS PARTICULAR CASE. IF YOU'RE DOING ACCOUNTING FOR AN ORDINARY BUSINESS, YOU MIGHT SAY, "OH, OUR NET WORTH IS SUCH-AND- SUCH AN AMOUNT." IF YOU'RE DOING ACCOUNTING FOR A BANK, THEN WE

15 ECO LECTURE WOULD TALK ABOUT THE CAPITAL ACCOUNTS. AND IF YOU'RE DOING ACCOUNTING FOR AN INDIVIDUAL, YOU MIGHT MENTION THEIR WEALTH. OKAY. BUT THE POINT IS IS THAT ALL OF THESE THINGS MEAN ABOUT THE SAME AND HERE'S HOW WE CALCULATE THIS. ASSETS MINUS LIABILITIES EQUAL EITHER NET WORTH OR CAPITAL OR WEALTH, DEPENDING ON WHICH - - WHO YOU'RE DOING THE ACCOUNTING FOR. OKAY. SO IF SOMEBODY'S ASSETS ARE TEN THOUSAND DOLLARS, THEIR LIABILITIES ARE EIGHT THOUSAND DOLLARS, THEN WE WOULD SUBTRACT THE ONE FROM THE OTHER AND SAY, "OH, THEIR NET WORTH IS TWO THOUSAND DOLLARS" OR "THEIR CAPITAL IS TWO THOUSAND" OR "THEIR WEALTH IS TWO THOUSAND." ARE YOU WITH ME ON THAT? AND HERE'S SOMETHING I'LL JUST CALL THE FUNDAMENTAL IDENTITY OF ACCOUNTING. THIS IS THE IDENTITY THAT MAKES IT ALL WORK. ASSETS EQUAL LIABILITIES PLUS -- I'M GONNA SAY -- WHAT AM I GONNA SAY -- CAPITAL, K. THESE ARE ALL CAPITAL LETTERS. THEY ALL REPRESENT DOLLAR AMOUNTS. WHY DID I USE CAPITAL? AND I TOLD YOU A MOMENT AGO THAT CAPITAL IS WHAT THE BANKERS TALK ABOUT. AND WE'RE GONNA BE TALKING ABOUT BANKS. THAT'S WHAT THIS WHOLE SUBJECT IS THAT WE'RE DISCUSSING. WE WANT TO UNDERSTAND THAT SIXTY PERCENT OF THE MONEY SUPPLY THAT COMES FROM BANKS. WELL, WE'RE GONNA DO A LITTLE ACCOUNTING FOR BANKS HERE IN A SECOND SO I WANTED TO USE CAPITAL. ANYWAY, HERE'S WHAT I WANT YOU TO NOTICE, THESE THREE LINES

16 ECO LECTURE RIGHT HERE. THIS IS A STRONGER STATEMENT THAN JUST SOMETHING EQUALS SOMETHING ELSE. THESE THREE LINES SAY THIS MUST BE TRUE BY DEFINITION. THE WAY THINGS ARE DEFINED, IT'S ABSOLUTELY GOTTA BE TRUE. IF THIS NUMBER, ASSETS, IS TEN THOUSAND DOLLARS AND THIS NUMBER, LIABILITIES, IS EIGHT THOUSAND DOLLARS, K JUST HAS TO BE WHATEVER IT HAS TO BE TO MAKE THIS STATEMENT TRUE. THIS JUST TAKES ON ANY VALUE. IT'D TAKE ON A ZERO VALUE OR A ZILLION DOLLARS, WHATEVER IT HAS TO BE TO MAKE THIS A TRUE STATEMENT. AND HERE THAT'S TWO, TWO THOUSAND DOLLARS. BUT THE POINT IS IS THE WAY THIS IS DEFINED, THE K IS FLEXIBLE. IT'S DETERMINED AT THE END WHEN WE KNOW THESE OTHER TWO. OKAY. NOW, HERE'S WHAT'S SO IMPORTANT ABOUT THAT FUNDAMENTAL IDENTITY OF ACCOUNTING IS THAT -- AND LET ME WRITE SOMETHING DOWN. WE'LL CALL THIS A T ACCOUNT. BOY, YOU'RE LEARNING A LOT OF NEW CONCEPTS TODAY, AREN'T YOU? HERE WE'LL PUT ASSETS ON ONE SIDE AND LIABILITIES PLUS CAPITAL ON THE OTHER SIDE. OKAY. HERE'S WHAT THIS FUNDAMENTAL IDENTITY -- AND YOU CAN SEE THAT ALL WE'VE DONE REALLY IS OUR T ACCOUNT'S GOT THE A ON THE ONE SIDE AND THE L PLUS K ON THE OTHER, JUST LIKE OUR FORMULA HAD HERE A MOMENT AGO. BUT HERE'S WHAT THIS IDENTITY DOES FOR US. IT CREATES A SITUATION THAT WE CALL DOUBLE ENTRY BOOKKEEPING. BECAUSE OF THE FUNDAMENTAL IDENTITY OF ACCOUNTING, THEN WE HAVE DOUBLE ENTRY BOOKKEEPING. WHICH IS TO SAY, EVERY TRANSACTION -- IF A BANK OR AN INDIVIDUAL OR SOMEBODY

17 ECO LECTURE GETS INVOLVED IN A TRANSACTION, EVERY SINGLE TRANSACTION WE'VE GOTTA RECORD TWO ENTRIES FOR THAT ONE TRANSACTION. AND LET ME GIVE YOU AN EXAMPLE. LET'S SAY I BUY A CAR AND WRITE A CHECK FOR TEN THOUSAND DOLLARS. WELL, LET'S RECORD THAT TRANSACTION. HERE WE GO. MINUS TEN THOUSAND DOLLARS IN TOM'S DD, MY CHECKING ACCOUNT. I'VE WRITTEN A CHECK FOR TEN THOUSAND DOLLARS TO BUY A CAR SO YOU SEE THE MONEY LEFT MY ACCOUNT, BUT I GET THE CAR PLUS TEN THOUSAND DOLLARS CAR. AND SO WHAT I'M SAYING TO YOU IS, WHEN WE HAD ONE TRANSACTION, THERE HAD TO BE TWO ENTRIES. SUPPOSE IT HAPPENED A LITTLE BIT DIFFERENT WAY -- AND I'LL CROSS THIS OUT, BUT I WON'T ERASE IT 'CAUSE I WANT TO LEAVE IT THERE FOR THE PURPOSE OF COMPARISON. BUT SUPPOSE SOMETHING HAPPENED LIKE THIS. I GO OUT AND I SAY, "HEY, WHY DON'T YOU SELL ME THAT CAR FOR TEN THOUSAND DOLLARS," AND YOU SAY, "OKAY." AND I SAY, "BUT I DON'T HAVE ANY MONEY. I'LL TELL YOU WHAT I WILL DO IS I'LL SIGN A NOTE, AN IOU, AND PAY YOU BACK LATER" AND YOU SAY, "OKAY." THEN HERE'S -- MY T ACCOUNT WOULD LOOK LIKE THIS: PLUS TEN THOUSAND DOLLARS DEBT. SO NOW THIS WOULD BE MY LIABILITY. I'VE OBTAINED THE SAME CAR BUT I'VE OBTAINED IT IN A DIFFERENT WAY, DIFFERENT WAY OF FINANCING THAT DEAL. BUT AGAIN, THAT ONE TRANSACTION, TWO ENTRIES IN THE ACCOUNT. ONE IS THE ASSET I GAINED, THE CAR; THE OTHER IS THE LIABILITY OR THE DEBT I'VE INCURRED. SO EVERY SINGLE TRANSACTION, BUYING, SELLING, ANYTHING.

18 ECO LECTURE WHATEVER IT IS. TWO ENTRIES. THIS IS REALLY -- AND THIS WAS DEVELOPED IN VENICE IN ABOUT, OH, I DON'T KNOW, 1300 A.D. WE WERE TALKING THE OTHER DAY ABOUT THE EARLY BANKERS. WELL, THOSE EARLY BANKERS IN VENICE WERE DEVELOPING -- AND IT WASN'T JUST THE BANKERS. IT WAS ALSO THE MERCHANTS OF VENICE, WHICH SHAKESPEARE WROTE A PLAY ABOUT. AND, YOU KNOW, SHAKESPEARE DIDN'T ACTUALLY WRITE THAT, THOSE PLAYS, BUT THERE'S A BIG DEBATE ABOUT WHO DID WRITE IT. ANYWAY, IN VENICE IN ABOUT 1300 A.D. THERE WERE -- IT WAS A VITAL ECONOMY, VERY ACTIVE. THERE WERE BANKS THERE BUT THERE WERE ALSO COMMERCIAL ENTERPRISES. THEY HAD OPERATIONS THROUGHOUT ITALY INTO EUROPE DOWN INTO NORTHERN AFRICA, MIDDLE EAST, JUST ALL OVER THE PLACE. AND TO CONTROL THEIR FAR-FLUNG BUSINESS EMPIRES, REALLY THE BIGGEST IN HISTORY IN TERMS OF JUST PRIVATE BUSINESSES, VENICE, GENOA -- THEY HAD HUGE BUSINESSES DURING THIS PERIOD. AND IN ORDER TO CONTROL THEIR LARGE BUSINESS ACTIVITIES, THEY HAD TO DEVELOP IMPROVED ACCOUNTING TECHNIQUES AND THEY WERE THE ONES WHO CAME UP WITH DOUBLE ENTRY BOOKKEEPING. I KEEP INHALING THIS -- THESE MARKERS AND IT MAKES ME COUGH. ANYWAY, SO THEY DEVELOPED THESE NEW ACCOUNTING METHODS AND EVER SINCE THEN, RIGHT UP UNTIL THE PRESENT TIME, WE USE THEIR TECHNIQUES TO DO ACCOUNTING. ANYWAY, SO HERE'S WHAT WE HAVE. WE'VE GOT A LITTLE BIT OF INFORMATION ABOUT THE BANKS AND THE

19 ECO LECTURE RESERVES -- MAN, MAYBE I NEED TO GO GET A DRINK -- AND WE'VE GOT SOME INFORMATION ABOUT ACCOUNTING. NOW WHAT WE WANT TO DO IS PUT ALL THIS STUFF TOGETHER. I'M GONNA HAVE TO ERASE A LITTLE, SO YOU CAN REFER TO YOUR NOTES. HERE'S WHAT WE WANT TO DO. LET'S JUST PRETEND -- AND IT'S NOT EXACTLY, IT DOESN'T -- OH, WE WANT TO MAKE ONE OTHER ASSUMPTION. ASSUME -- MAYBE NOT ONE OTHER ASSUMPTION BUT MAYBE A COUPLE OR THREE. ONE, ASSUME PEOPLE HOLD NO CURRENCY. THIS IS JUST FOR THE TIME BEING. IN REAL LIFE THEY DO AND WE'LL ADJUST FOR THAT LATER ON. PEOPLE HOLD NO CURRENCY. ASSUME THAT BANKS HOLD NO EXCESS RESERVES. AND THIS IS -- AGAIN, THESE ARE SIMPLIFIED ASSUMPTIONS TO ALLOW US TO DO WHAT WE'RE GETTING READY TO DO A LITTLE BIT EASIER. THEY DON'T CHANGE OUR CONCLUSIONS. BUT THE FINAL ASSUMPTION: ASSUME THERE'S ONLY ONE BANK. HERE'S WHAT WE'LL ASSUME: WE'LL LET ON LIKE ALL THE BANKS THAT ARE OUT THERE ARE REALLY JUST BRANCHES OF, YOU KNOW, LIKE ONE BANK. IN REALITY THAT'S NOT TRUE, BUT IT DOES NOT CHANGE OUR CONCLUSIONS AND IT MAKES THE DISCUSSION A LOT SIMPLER SO WE'LL MAKE THIS ASSUMPTION. NOW, LET'S GET THE BALL ROLLING. WE'LL START OFF THIS WAY. LET ME JUST KIND OF -- I DON'T KNOW IF I CAN DRAW A PICTURE OF THIS. ASSUME THE FEDERAL RESERVE COMES FLYING OVERHEAD WITH A HELICOPTER, BEAUTIFUL HELICOPTER, AND THEY JUST THROW OUT -- LET'S SAY TEN ONE HUNDRED DOLLAR BILLS. THROW OUT A THOUSAND DOLLARS,

20 ECO LECTURE BUT JUST THROW 'EM OUT THE WINDOW JUST AT RANDOM AND THEY JUST KIND OF FLOAT TO EARTH AND SOMEBODY PICKS 'EM UP. OKAY. SO THE FED -- THAT'S OUR STEP ONE. THE FED INJECTS TEN THOUSAND DOLLARS -- ONE THOUSAND DOLLARS INTO THE ECONOMY. THEY'VE THROWN THIS MONEY OUT OF THE HELICOPTER. AND THE FIRST THING THAT HAPPENS IS THERE'S AN INCREASE IN THE M-1 MONEY SUPPLY EQUAL TO ONE THOUSAND DOLLARS. BOY, YOU DIDN'T HAVE TO GO TO COLLEGE IN ORDER TO LEARN THAT MUCH, DID YOU? IF THE FEDERAL RESERVE FLIES A HELICOPTER OVERHEAD AND THROWS OUT TEN ONE HUNDRED BILLS, THE MONEY SUPPLY WILL GO BY A THOUSAND DOLLARS. OOOH, PINCH ME. THAT IS A REAL REVELATION. STEP TWO. DEPOSIT THE ONE THOUSAND DOLLARS AT BANKS. THAT IS TO SAY, THE PEOPLE WHO PICKED THAT MONEY UP, WE SAID THAT THEY DO NOT WANT TO HOLD CURRENCY. THAT WAS ONE OF OUR ASSUMPTIONS. PEOPLE WILL NOT HOLD CURRENCY. AND SO THE STEP TWO IS PEOPLE ARE GONNA PUT THAT MONEY AT THE BANK. OKAY. NOW, LET'S PUT A T ACCOUNT UP HERE. HERE'S THE BANK'S T ACCOUNT. WE'LL PUT -- AND, BY THE WAY, I'M GONNA SIMPLIFY THIS. I'M NOT GONNA PUT ALL THEIR ASSETS AND ALL THEIR LIABILITIES UP THERE. I'M ONLY GONNA RECORD THE CHANGES, THE NEW ASSETS AND THE NEW LIABILITIES. AND I'LL PUT THAT LITTLE DELTA SIGN UP THERE TO SHOW CHANGES PLUS -- CHANGES AND CAPITAL. WE'RE ONLY RECORDING CHANGES, NOT -- AND OTHERWISE I'D HAVE TO SHOW ALL THE BANK'S ASSETS, ALL OF ITS LIABILITIES. I'M NOT

21 ECO LECTURE GONNA DO THAT. WE'LL JUST SHOW NEW ASSETS AND NEW LIABILITIES. OKAY. AND HERE'S THESE -- LET'S JUST SAY ONE GUY PICKED UP ALL THIS MONEY AND THE GUY'S NAME IS BOB. FOR BOB WE'LL CALL IT HIS WEALTH. OKAY. NOW, THE FIRST TRANSACTION WHERE THE FED THROWS THIS MONEY OUT OF THE HELICOPTER, HERE'S WHAT BOB SAYS: "HEY, I GOT A BUNCH OF ONE HUNDRED DOLLAR BILLS, CASH. AND THAT WAS AN ADDITION TO MY WEALTH. I DON'T OWE IT TO ANYBODY. I'M JUST A THOUSAND DOLLARS RICHER THAN I USED TO BE." ALL RIGHT? YOU DIDN'T HAVE TO GO TO COLLEGE TO LEARN THAT. OR HOW DO THEY NORMALLY SAY IT: YOU DON'T HAVE TO BE A ROCKET SCIENTIST TO UNDERSTAND THIS. NOW, THE SECOND STEP, THOUGH, IS BOB'S GONNA PUT THAT MONEY AT THE BANK. SO LET'S RECORD THAT TRANSACTION. BOB SAYS, "HEY, I WANT TO HAND OVER THIS THOUSAND DOLLARS IN CASH TO THE BANK," AND THE BANKER THEN GETS THE THOUSAND DOLLARS, VAULT CASH. THIS IS REALLY -- I SHOULDN'T CALL IT CASH WHEN IT WAS THAT INDIVIDUAL. I SHOULD CALL IT CURRENCY 'CAUSE THAT'S WHAT IT IS, YOU KNOW. THAT'S THE OFFICIAL TERM FOR IT. SO ANYWAY, BOB HANDS A THOUSAND DOLLARS OVER TO THE BANK AND THE BANKER TAKES THE THOUSAND DOLLARS. AND THEN BOB SAYS, "HEY, YOU KNOW ABOUT THAT WHOLE IDEA OF DOUBLE ENTRY BOOKKEEPING. THERE'S ANOTHER HALF TO THIS TRANSACTION." AND THE BANKER SAYS, "OH, YEAH. WE FORGOT." AND SO THEN THE BANKER SAYS, "WE'LL PUT A THOUSAND DOLLARS IN YOUR CHECKING

22 ECO LECTURE ACCOUNT." DD, BOB. AND THEN FOR THE BANKER THEY SAY, "BOB, WE OWE YOU A THOUSAND DOLLARS." DD, BOB. SO THAT'S STEP ONE AND STEP TWO. LET'S KIND OF GO BACK AND LOOK AND SEE -- WELL, WE'VE ALREADY TALKED ABOUT A LITTLE BIT OF THIS. WHAT HAPPENED AS A RESULT OF STEP ONE, THE FED THREW THE THOUSAND DOLLARS OUT OF THE WINDOW, AND THE ANSWER IS THE MONEY SUPPLY WENT UP BY A THOUSAND DOLLARS, RIGHT? INCREASING THE MONEY SUPPLY ONE THOUSAND DOLLARS. INCREASE M-1 EQUALS ONE THOUSAND DOLLARS. THAT'S STEP ONE. STEP TWO, WHAT HAPPENED? STEP TWO, THAT'S WHEN BOB PUT THE THOUSAND DOLLARS IN HIS BANK ACCOUNT. NOW, YOU KNOW, IF WE'RE TALKING ABOUT M-1 -- AND WE ARE TALKING ABOUT THE M-1 MONEY SUPPLY -- HERE'S ALL THAT HAPPENED. BOB GAVE UP ONE KIND OF M-1 MONEY, CASH MONEY, AND GOT ANOTHER KIND OF M-1 MONEY, CHECKING ACCOUNT MONEY, SO THAT DID NOT AFFECT THE MONEY SUPPLY. NO CHANGE IN M-1. THAT WAS TRANSACTION TWO. AND SO NOW WE WANT TO GO ON TO STEP THREE. WE WANT TO SEE WHAT BANKS DO. STEP THREE, BANK DOES WHAT? LET'S LOOK BACK OVER HERE. AND I'VE ALREADY TOLD YOU NOW THAT BANKERS HOLD NO EXCESS RESERVES. SO LET'S COME BACK AND SEE WHAT HAPPENED TO THE BANKER SITUATION. THE BANKER GOT TOTAL RESERVE OF A THOUSAND DOLLARS. I'M GONNA ERASE THIS IN A SECOND, BUT I JUST WANT TO MAKE

23 ECO LECTURE SOME NOTES HERE. THE BANKER'S GOT SOME REQUIRED RESERVES OF TEN PERCENT -- DID I SAY TEN PERCENT? WELL, I DIDN'T MAKE UP ONE OF THESE. LET'S SAY A REQUIRED RESERVE RATIO IS EQUAL TO TEN PERCENT. THAT'LL BE OUR ASSUMPTION WE WORK WITH. AND SO THE BANKER SAYS, "WELL, I'VE GOTTA HOLD ONE HUNDRED DOLLARS ON RESERVE." AND SO THEN THE BANKER SAYS, "I'VE GOT EXCESS RESERVES OF NINE HUNDRED DOLLARS." YOU WITH ME? THE BANKER GOT A DEPOSIT THAT WENT IN THE VAULT. THAT'S VAULT CASH, IT'S A THOUSAND BUCKS. THE BANKER ONLY HAS TO HOLD TEN PERCENT OF THAT THOUSAND DOLLAR DEMAND DEPOSIT THAT CAME INTO THE BANK SO THE BANKER'S GOT EXCESS RESERVES. BUT WE ASSUMED THAT BANKERS HOLD NO EXCESS RESERVES. WELL, THEY DON'T WANT TO. AND SO WHAT THIS BANKER SAYS IS, "MAN, I GOT NINE HUNDRED DOLLARS. IT'S BURNING A HOLE IN MY POCKET. WHAT AM I GONNA DO WITH THIS NINE HUNDRED DOLLARS?" AND ABOUT THAT TIME SOMEBODY NAMED SALLY COMES WALKING INTO THE BANK. SALLY COMES WALKING INTO THE BANK AND SAYS, "I'D LIKE TO SEE A LOAN OFFICER." THE BANKER SAYS, "COME ON OVER HERE AND HAVE A SEAT. WHAT CAN I DO FOR YOU?" AND SALLY SAYS, "I WANT TO BORROW NINE HUNDRED DOLLARS." AND THE BANKER SAYS, "OH, THIS IS MY LUCKY DAY." HE DIDN'T SAY THAT TO SALLY 'CAUSE HE WANTS TO LET ON LIKE, YOU KNOW, I CAN TAKE IT OR LEAVE IT. BUT INSIDE HE'S THINKING, "OH, THIS IS JUST SO WONDERFUL." AND SO THE BANKER SAYS, "WELL, WHAT DO YOU WANT THE NINE

24 ECO LECTURE HUNDRED DOLLARS FOR?" AND SHE SAYS, "OH, I JUST WANT TO BUY SOME NEW CLOTHES AND THINGS LIKE THAT." AND THE BANKER SAYS, "OKAY, COME ON IN, SALLY. FILL OUT THIS FORM AND WE'LL PROCESS ALONG," AND A FEW MINUTES LATER HE SAYS, "WE'RE ALL DONE WITH IT." SHAKE HANDS AND SALLY SAYS, "WHERE'S MY MONEY?" AND THE BANKER SAYS, "ONE SECOND, WE'LL DO THE ACCOUNTS." AND SO THEN THE BANKER SAYS -- THIS IS FOR THE LOAN. LET ME PUT A LITTLE HASH MARK THROUGH THERE. AND SO HE SAYS TO SALLY, "OKAY, SALLY, YOU FILL OUT THIS IOU." AND SHE DOES AND THE BANKER ADDS THAT OVER HERE. IT SAYS LOAN TO SALLY. THIS IS AN ASSET OF THE BANKER. THE BANKER'S GOT SALLY'S IOU. SO IT'S AN ASSET. TO SALLY, THAT IS A LIABILITY. PLUS NINE HUNDRED DOLLAR DEBT TO BANK. OKAY. SO THE BANK GETS SALLY'S NOTE. IT'S THE BANK'S ASSET, IT'S SALLY'S LIABILITY, AND THEN SALLY SAYS, "WHERE'S THE REST?" AND THE BANKER SAYS, "OH, YEAH, YEAH. SALLY, WHAT WE'RE GONNA DO, WE'RE GONNA PUT NINE HUNDRED DOLLARS IN YOUR CHECKING DEPOSIT. NOW THAT YOU'VE BORROWED THIS MONEY, WE'RE GONNA PUT THAT MONEY IN YOUR CHECKING DEPOSIT," AND SALLY SAYS, "OKAY." SO FOR HER THAT'S A NINE HUNDRED DOLLAR ASSET, DEMAND DEPOSIT AT THE BANK. BUT FROM THE BANKER'S POINT OF VIEW, IT'S A LIABILITY. WE'VE GOT SALLY'S MONEY. SHE CAN TAKE THIS ANY TIME SHE WANTS. HERE'S WHAT WE WANT TO SEE AT THIS POINT -- AND THAT'S THE END OF THAT TRANSACTION, BY THE WAY. THAT WAS STEP THREE. BANK LOANS NINE HUNDRED DOLLARS TO CUSTOMER. ANYWAY, LET'S COME BACK.

25 ECO LECTURE HERE'S WHAT I WANT YOU TO SEE. NUMBER ONE, THE BANKER ONLY LENT OUT THE VALUE OF ITS EXCESS RESERVES. IT HAD NINE HUNDRED DOLLARS IN EXCESS RESERVES, IT LENT OUT NINE HUNDRED DOLLARS. NOT A PENNY MORE. OKAY. AND THE SECOND THING THAT I WANT YOU TO SEE IS FOR THE THIRD TRANSACTION -- HEY, LOOK. THERE'S NINE HUNDRED DOLLARS IN CHECKING ACCOUNT MONEY THERE WASN'T A MOMENT AGO, THAT DIDN'T EXIST A MOMENT AGO, RIGHT? YOU CAN SEE IT ON SALLY'S BOOKS; WE CAN SEE IT ON THE BANK'S BOOKS. ARE YOU WITH ME? BOB'S STILL GOT HIS THOUSAND DOLLARS AT THE BANK. THAT WAS THE THOUSAND DOLLARS HE PICKED UP OUT ON THE GROUND AND HE MADE A DEPOSIT AT THE BANK. HE'S STILL GOT A THOUSAND DOLLARS AT THE BANK. SO THAT THOUSAND DOLLARS STILL EXISTS IN M-1 MONEY SUPPLY. BUT NOW THE BANKER HAD SOME EXCESS RESERVES FROM BOB'S DEPOSIT AND MADE A LOAN OF THE EXCESS RESERVES, AND NOW THE MONEY SUPPLY HAS GONE UP AGAIN. INCREASE IN M-1 EQUAL TO NINE HUNDRED DOLLARS. SALLY'S BORROWED THAT MONEY. WHAT DID SHE WANT? SHE WANTED SOME CLOTHES. AND SO OVER HERE WE WILL HAVE STAN, THE CLOTHING MAN WHO SELLS CLOTHES, CHANGES IN ASSETS, CHANGES IN LIABILITIES, PLUS CHANGES IN WEALTH. AND SALLY GOES TO STAN AND SAYS, "HEY, STAN. I WANT TO BUY, YOU KNOW, SOME DRESSES, SOME SHOES, WHATEVER FROM YOU, AND I'LL WRITE MY CHECK." SO THEN HERE'S WHAT SHE SAYS: PLUS NINE HUNDRED DOLLARS WORTH OF CLOTHES -- THAT'S HER ASSETS, AND

26 ECO LECTURE REALLY HER MAIN ASSET. IF YOU'VE NEVER MET HER YOU WOULD KNOW THAT -- OR IF YOU'D EVER MET HER. SO SHE'S GOT NINE HUNDRED DOLLARS WORTH OF CLOTHING BUT THEN SHE HAD TO WRITE A CHECK FOR NINE HUNDRED DOLLARS SO THAT'S REDUCED CHECKING DEPOSIT THAT SHE HAS. STAN, HE'S GOT NINE HUNDRED DOLLARS LESS IN CLOTHING BECAUSE HE SOLD THAT, NINE HUNDRED DOLLARS OF CLOTHING, BUT HE DOES HAVE ANOTHER NINE HUNDRED DOLLARS IN HIS CHECKING DEPOSIT. AND OVER AT THE BANK, THE BANKER -- REALLY, HE'S THE BANKER FOR BOTH SALLY AND STAN, AND SO HERE'S WHAT THE BANKER SAYS, "SALLY, WE NO LONGER OWE YOU NINE HUNDRED DOLLARS," DD SALLY, "AND THE REASON FOR THAT IS YOU WROTE A CHECK ON THAT ACCOUNT. BUT STAN, NOW YOU'VE MADE A DEPOSIT SO WE OWE YOU NINE HUNDRED DOLLARS," DD STAN. THIS PROCESS CONTINUES. THE BANKER NOW IS GONNA SAY, "OH, GOSH. WE GOT ANOTHER NINE HUNDRED DOLLARS COMING IN THAT STAN GAVE US. WE'VE GOTTA HOLD REQUIRED RESERVES TEN PERCENT OF THAT. WE'VE GOTTA HOLD NINETY DOLLARS. BUT NINE HUNDRED CAME IN. AND SO IF TOTAL RESERVES CAME IN OF NINE HUNDRED DOLLARS AND WE'RE REQUIRED TO HOLD NINETY, THEN OUR EXCESS RESERVES WOULD BE -- WHAT WOULD THAT BE -- EIGHT HUNDRED AND TEN DOLLARS." THEN THE BANK WOULD MAKE ANOTHER LOAN JUST LIKE -- WHERE WAS THAT PREVIOUS LOAN? BANK LOANS. THERE WE GO. THE NEXT LOAN THE BANK WOULD MAKE WOULD BE EIGHT HUNDRED AND TEN DOLLARS. INCREASE IN M-1 EQUALS EIGHT TEN. THE BANKER LENDS OUT ONLY THE VALUE OF

27 ECO LECTURE EXCESS RESERVES. HERE'S WHAT YOU SHOULD SEE. EVERY TIME THE BANKER MAKES A LOAN, AND THAT'S WHAT WE SET OUT TO DISCUSS, WHERE DOES THAT CHECKING ACCOUNT MONEY COME FROM? EVERY TIME THE BANKER MAKES A LOAN, THAT BANKER SAYS, "HEY, I'LL PUT THE MONEY IN YOUR CHECKING ACCOUNT." AND THAT CHECKING ACCOUNT MONEY IS BEING CREATED ALONG THE WAY WHEN THE BANKER MAKES A LOAN. LET'S LOOK AT THIS. WE GOT A THOUSAND DOLLARS WHEN THE FED PUT A THOUSAND DOLLARS IN THE ECONOMY, NOW ANOTHER NINE HUNDRED, NOW ANOTHER EIGHT TEN, WE'RE UP TO TWENTY-SEVEN HUNDRED AND TEN DOLLARS ALREADY WITH OUR MONEY SUPPLY FROM THAT ORIGINAL ONE THOUSAND. AND WHERE WE'RE REALLY HEADED WITH ALL THIS IS TO SAY THAT THERE IS A MULTIPLIER. A MULTIPLIER EFFECT, THAT AMOUNT OF MONEY THAT THE FED PUT INTO THE ECONOMY GETS MULTIPLIED MANY TIMES OVER IN ORDER TO DETERMINE THE MONEY SUPPLY. AND IN THIS PARTICULAR CASE, THE MULTIPLIER IS EQUAL TO ONE OVER R EQUALS ONE OVER POINT ONE ZERO, TEN PERCENT RESERVE REQUIREMENT, EQUALS TEN. THAT IS TO SAY IF WE WERE TO JUST STAY HERE WITH THESE ACCOUNTS AND DO ONE AFTER ANOTHER OF THESE, WE WOULD SEE THE TOTAL MONEY SUPPLY GO FROM THAT ORIGINAL THOUSAND BUCKS UP TO TEN TIMES THAT AMOUNT THROUGH THE PROCESS OF BANKERS MAKING LOANS AND THERE'D BE A CREATION OF NEW CHECKING ACCOUNT MONEY IN THE ECONOMY. THE TOTAL MONEY SUPPLY WOULD GO UP TO TEN THOUSAND DOLLARS.

28 ECO LECTURE WE'LL PICK UP WITH THAT NEXT TIME. SO LONG.

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