are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. Let’s see how.
Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is shown in Figure 1. At this stage, Singleton Bank is simply storing money for depositors; it is not using these deposits to make loans, so it cannot pay its depositors interest either.
The assets are reserves ($10 million). The liabilities + net worth are deposits ($10 million).
Figure 1. Singleton Bank’s Balance Sheet: Receives $10 million in Deposits.
Singleton Bank is required by the Federal Reserve to keep 10% of total deposits, or $1 million, on reserve to cover withdrawals. It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank and make interest payments to depositors (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.
This change in business plan alters Singleton Bank’s balance sheet, as shown in Figure 2. Singleton’s assets have changed; it now has $1 million in reserves and a loan to Hank’s Auto Supply of $9 million. The bank still has $10 million in deposits.
The assets are reserves ($1 million) and loan to hank’s auto supply ($9 million). The liabilities + net worth are deposits ($10 million).
Figure 2. Singleton Bank’s Balance Sheet: 10% Reserves, One Round of Loans
Singleton Bank lends $9 million to Hank’s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that a loan has been made. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer is not going to let Hank walk out of the bank with $9 million in cash. The bank issues Hank’s Auto Supply a cashier’s check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million, as Figure 3 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest.
The assets are reserves (+ $9 million). The liabilities + net worth are deposits (+ $9 million).
Figure 3. First National Bank’s Balance Sheet: Required 10% Reserves
Since the loan to Hank was deposited into a demand deposit account (Hank’s checking account), the loan increases the M1 money supply. Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable
Explanation:
Because all currencies are fiat currencies, which means they are NOT backed by gold & silver. This allows private banks to create money out of thin air and lend it to governments. This is the root of inflation and the recent financial crisis.
If you think about the following: 2,000 years in Ancient Rome you could walk into a clothes store and with a one ounce gold coin you could buy yourself a nice robe, sandals, etc. and get well dressed for one gold coin. Today you walk into a department store in NYC, London, Milan or Tokyo and with a one ounce gold coin you can buy yourself a suit, shirt, tie, socks, shoes & belt. The value of a one ounce gold coin today in just over USD$1,700. Interesting to see that a gold coin 2,000 years ago buys you the same today.
If you look into monetary history you'll find that every time currencies were backed by gold & silver there was no inflation and economy thrived. The sooner we go back to this system, the sooner the economy will sort itself out.
The good thing is that the Swiss government are going to have circulate Swiss Franc gold coins as an alternative currency to the paper money Swiss France in Autumn this year. In Utah, USA a silver coin currency is already circulating as an alternative to the US dollar, 12 other US states are about to follow. Also the Mexican government is about to approve the circulation of silver coins as an alternative to the peso. So it's already coming...
