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Login Register. To demonstrate how this miracle of modern banking came about, consider this simple story:. Once upon various times, pretty much anything was used as money. It just had to be portable and enough people had to have faith.
Shells, cocoa beans, pretty stones, even feathers have been used as money. Before long, the goldsmith was renting every shelf in the vault and earning a small income from his vault rental business. Depositors rarely came in to remove their actual, physical gold, and they never all came in at once. That was because the claim checks the goldsmith had written as receipts for the gold,.
This paper money was far more convenient than heavy coins, and amounts could simply be written,. As industry expanded more and more people asked the goldsmith for loans.
He knew that very few of his depositors ever removed their actual gold. So, the goldsmith figured he could easily get away with lending out claim checks against his depositors' gold,. As long as the loans were repaid, his depositors would be none the wiser, and no worse off.
For years the goldsmith secretly enjoyed a good income from the interest earned on everybody else's deposits.
Now a prominent lender, he grew steadily richer than his fellow townsmen and he flaunted it. His depositors got together and threatened withdrawal of their gold if the goldsmith didn't come clean about his newfound wealth.
Contrary to what one might have expected, this did not turn out to be a disaster for the goldsmith. Despite the duplicity inherent in his scheme, his idea did work. The depositors had not lost anything. Their gold was all safe in the goldsmith's vault. Rather than taking back their gold, the depositors demanded that the goldsmith, now their banker,.
The banker paid a low interest rate on deposits of other people's money that he then loaned out at a higher interest. The difference covered the bank's cost of operation and its profit. And it seemed like a reasonable way to satisfy the demand for credit.
And the demand for credit was growing fast, as Europeans spread out across the world. But his loans were limited by the amount of gold his depositors had in his vault.
Since no one but himself knew what was actually in his vaults,. As long as all the claim check holders didn't come to the vault at the same time and demand real gold, how would anyone find out? This new scheme worked very well, and the banker became enormously wealthy. The idea that the banker would just create money out of nothing was too outrageous to believe,.
But, the power to just invent money went to the banker's head as you can well imagine. In time, the magnitude of the banker's loans and his ostentatious wealth did trigger suspicions once again. Some borrowers started to demand real gold instead of paper representations. Rumors spread. Suddenly, several wealthy depositors showed up to remove their gold. The game was up! A sea of claim check holders flooded the street outside the closed doors of the bank.
This is called a "run on the bank" and is what every banker dreads. This phenomenon of a "run on the bank" ruined individual banks and, not surprisingly,. It would have been straightforward to outlaw the practice of creating money from nothing. But the large volumes of credit the bankers were offering had become essential to the success of European commercial expansion.
Bankers agreed to abide by limits on the amount of fictional loan money that could be lent out. The limit would still be a number much larger than the actual value of gold and silver in the vault. Quite often the ratio was 9 fictional dollars to 1 actual dollar in gold. Over the years, the fractional reserve system and its integrated network of banks backed by a central bank. At the same time, the fraction of gold backing the debt money.
In the past, a paper dollar was actually a receipt that could be redeemed for a fixed weight of gold or silver. In the present, a paper or digital dollar can only be redeemed for another paper or digital dollar. In the past, privately created bank credit existed only in the form of private banknotes, which people had the choice to refuse.
In the present, privately created bank credit is legally convertible to government issued "fiat" currency,. Fiat currency is money created by government fiat, or decree, and legal tender laws declare that citizens must accept this fiat money. In the past, the total amount of money in existence was limited to the actual physical quantities.
For example, in order for new gold or silver money to be created,. In the present, money is literally created as debt. New money is created whenever anyone takes a loan from a bank. As a result, the total amount of money that can be created has only one real limit - the total level of debt. Governments place an additional statutory limit on the creation of new money,. Essentially arbitrary, fractional reserve requirements vary from country to country and from time to time.
In the past, it was common to require banks to have at least one dollar's worth of real gold in the vault. Today, reserve requirement ratios no longer apply to the ratio of new money to gold on deposit,.
However the bank's investors have made a reserve deposit of one thousand one hundred and eleven dollars and twelve cents. Step 1: The doors open and the new bank welcomes its first loan customer. At a reserve ratio, the new bank's reserve at the central bank, also known as "high-powered money",. It is brand new money simply typed into the borrower's account as bank credit. The borrower then writes a check on that bank credit to buy the used car.
Unlike the high-powered government money deposited at the central bank, this newly created credit money cannot be multiplied by the reserve ratio. Like one of those Russian dolls, each layer of which contains a slightly smaller doll inside, each new deposit contains the potential. Now, if the loan money created is not deposited at a bank, the process stops. That is the unpredictable part of the money creation mechanism. But more likely, at every step, the new money will be deposited at a bank, and the reserve ratio process.
All of this new money has been created entirely from debt, and the whole process legally authorized by the initial reserve deposit. What's more, under this ingenious system, the books of each bank in the chain must show.
This gives banks a very real incentive to seek deposits. Now, unless all the successive loans were deposited at the same bank,. However, the banking system is a closed loop, bank credit created at one bank becomes a deposit in another, and vice versa. In a theoretical world of perfectly equal exchanges, the ultimate effect would be exactly the same.
That is, the bank's initial central bank reserve of a little over eleven hundred dollars. If that sounds ridiculous, try this.
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