Day61.md

Traditional Finance System

Let's learn how a bank works. Every hardworking person in society provides a service and has savings. Their money in their house is doing nothing. They got their savings from the people for whom they'd provided service. There's some guy who has a good idea for a project for which he or she could make a decent amount of money. But how will he or she persuade others to contribute to the project? He or she could promise to give something in the future once the project finishes, but no one will be willing to work for him or her unless they feel really secure that they're going to get something in return.

We have an interesting problem. There are a bunch of people who provide services and have savings in the form of gold or paper money, and there's another group that has an awesome idea but no capital to start with. So what if the entrepreneur could borrow some savings from another group? The entrepreneur could generate wealth and share it with other groups. However, it is extremely difficult for the group to evaluate an entrepreneur's project idea, especially when the project may necessitate the rescue of thousands of people.Also, it'll be hard for one group to evaluate who has a good project and who has more savings.

Someone saw this opportunity and called a business "Bank." Let's say I have a million dollars in savings, and I've used that to build the structure of a solid, safe, and secure vault. So my "equity" is $1 million. People will be comfortable keeping their money here, and they'll feel safe too. So, instead of keeping your money insecure in your home, why not put it in my vault? If you ever need it, you can come and get it, and on top of that, I'll pay you interest. So everyone puts their savings, which, let's say, is $10 million in deposits, which is a "liability" for me because I owe that to other people. I told people that they could take money at any time, so I need to put some cash aside in case people want their money back.

So let's say 10% of $10 million is $1 million in reserve, and then I've got $9 million left that I can hopefully put to productive use. I loan that money to people who have really good projects or investments, which are "assets," because they own me that amount. I'm borrowing $10 million, keeping $1 million in reserve, and paying out $9 million in loans. A loan could be given to multiple projects.

How am I making money?

I hope to use the loan for irrigation, factory construction, or any other investments that generate more value than they cost to begin with. So I can charge interest, and it should be a cut of the value that's been created. Let's say I'm charging 10% on the loan and assume all my payout loans are on the best project. Also, I'm paying 5% interest on the deposited amount. So how much money do I make?

So I'm making 10% on $9 million, which is $900,000 a year, and I'm paying out 5% of $10 million, which is $500,000. That leaves me with $400,000 left over. Assume I spent another $100,000 on salaries, security, and other expenses. I'm netting $300,000. So in the big picture, I'm putting in $1 million every year and making $300,000 by matching up the savings with good investments, and everyone benefits.

Income Statement

Let's continue with the previous example where I started a bank and matched up savers with an investment opportunity. So my balance sheet for the first year is:

• One million dollars in equity
• purchased a building (a bank), resulting in a $1 million real estate investment.
• Collect $10 million in deposits.
• set a reserve of $1 million.
• $9 million loan on a good investment
• Getting 10% interest on a loan
• Giving 5% interest to savers

So what happens over the course of the year? How much interest income am I going to get? Interest income is $900,000, interest expense is $500,000, and operations, maintenance, and salaries are $100,000. I'm left with $300,000 in pre-tax earnings. So they take 1/3, so it's $100K, and I'm going to be left with $200,000, which is my "net income." This is the income statement. So what is my balance sheet going to look like at the end of the year?

$9 million of loans in my assets column Spend some money on maintenance so that the building is still worth $1 million. Now I have $1.2 million in reserves, and I'm assuming that my level of deposits doesn't change. $10 million in deposits The difference between total assets and total liabilities is defined as equity. So there are $11.2 million in total assets and $10 million in total liabilities. So $1.2 million of equity

I had $1 million of equity, and now I've got $1.2 million of equity. So the change in equity is $200,000, which is the same thing as net income. A "balance sheet" is just a snapshot of what you have and owe at a given point in time. The "Income Statement" tells us what happened over the course of the year. It tells how we got from one balance sheet to another. It tells you all of your inputs and outputs and where your money went.

So if you have a positive net income, the balance sheet equity will increase by that amount, and if you have a negative net income, the balance sheet will decrease in a year. Net income is the change in equity. Your initial equity was $1 million. So how much money did you make? It grew by $200K. So 20% is 200K/1 million. It's the "return on equity," which is the same thing as the "change in equity" / "starting equity."

Fractional Reserve

Now let's understand what money is and how it's created.

So I'm thinking that at the end of the season, all of the farmers will sell all of their apples and receive 1,000 gold pieces. They're storing these gold pieces in their house. But there are good projects and no money for those people to build those things. I could take 1,000 pieces of gold and use them for those projects, and then it would actually create wealth. So I opened the bank.

I personally have 100 gold pieces, and I constructed the building, which is worth 100 gold. Then I tell farmers that if they deposit money in my bank, I'll give them interest. So they all deposited 1,000 gold pieces into my bank. Now I have 1,000 gold pieces in liabilities because I owe them to the farmers. Essentially, I set aside 100 ounces of gold in case a single farmer withdraws the gold from the bank. I lend out the remaining 900 gold pieces. I loaned it to someone who has an irrigation project and plans to pay a lot of people with those 900 gold pieces. They plan to build an irrigation canal so that more land can be used to grow apples.

The 900 gold pieces will be distributed to irrigation project workers. After the project is done, you'll have a bunch of workers and 900 gold pieces in total. Just like farmers, they go back to my bank and deposit money my bank.So I'll set aside 10% of 900, which is 90 gold, and lend the remaining 810 to some guy who wants to build a factory. Once again, those 810 gold pieces go to the construction workers and are deposited in my bank. I could go on and on, but it's not an infinite process because with each step we get a little bit less. Let's stop it here. So I keep all 810 gold pieces as reserves. Assets are equal to liabilities plus equity.

So how much money is there in the system?

It all depends on how you define money. So I define one by saying M0, which is just how much gold is there? Counting all the reserves, we get 810 + 90 + 100 = 1000 gold. That makes sense because we started with 1,000 ounces of gold and didn't mine any.

Let's use another definition, M1, which is how much money people think they have. Well, the farmers think they have 1000 gold pieces, the irrigation workers think they have 900 gold pieces, and the factory workers think they have 810 gold pieces. So there are 27,10 grams of gold in total. This is the "multiplier effect." This happens whenever you have a "fractional reserve." This is what people say when they talk about "creating money people think they have." Well, the farmers think they have 1000 gold pieces, the irrigation workers think they have 900 gold pieces, and the factory workers think they have 810 gold pieces. So there are 27,10 grams of gold in total. This is the "multiplier effect." This happens whenever you have a "fractional reserve." This is what people say when they talk about "creating money." We've got 1000 gold pieces, and due to the multiplier effect, people think they've got 2710 gold pieces.

The multiplier effect and the money supply

whether it's fair for people to think that they really have the money that they have.

So after the crop was harvested, the farmer deposited 1000 gold pieces in my bank, then I lent out 900 to the irrigation project and kept 100 in my reserve. Irrigation paid 900 gold pieces to a bunch of workers, who put them back in my bank. I get 900 gold pieces as deposits, keep 90 in my reserve, and lend out 810 gold pieces to build a factory. That entrepeneur takes that 810 gold and pays the builder, which they again deposit in my bank, and I stopped the chain.

We made one definition of money called m0, which is our narrowest definition and is literally how much gold is in our system that could be immediately used for conducting a transaction. For this argument, I'm assuming none of these players kept anything in their pockets. So there are 1000 gold pieces in the bank because we originally had 1000 gold pieces.

There's more interest here if you go around the city and ask people how much money they have; they will tell you how much is in my checking account. They will tell you how much they have in their checking account. So 810 from factory workers, 900 from irrigation project workers, and 1000 from farmers, which is 2710 collectively in our checking account, which we'll call m1,

So how did 1,000 gold pieces turn into 2710 gold pieces? Does this $2710 represent real wealth or some weird pyramid scheme?

So, how did it come to be? We went through the mechanics. It represents real wealth if each of the investments in the bank were real investments. If 900 gold pieces to build the irrigation system generate at least 900 gold pieces of future wealth, then it's a real asset. Similarly, the factory But there are not 2710 gold pieces in our example world, but if the projects are real, then we do have 2710 gold pieces' worth of wealth. Gold is not wealth in itself. It's a representation of wealth. M1 was expanded to facilitate real economic production. As long as those projects generate wealth, the money supply doesn't grow faster than the amount of wealth out there. Before the gold piece bought an apple, now it'll hopefully still buy an apple.

In fact, if the investments are very good and the irrigation project goes well, we will double our apple production from 1,000 to 2,000. Likewise, the factory takes us from 2000 to 3000. So now, in a given year, how many apples are produced? If we still have 2710 gold pieces' worth of gold after producing 3000 apples, our money supply grew slower than our wealth. Money is used to transact wealth. It's not wealth in and of itself.

The ratio of gold to apples has actually improved, and now an apple is going to cost less gold before we're producing 1000 apples per year. Because of our innovation, we've experienced deflation.

Bank Notes Let's go back to our example. I've got a bank that has 100 gold pieces of equity, and I use that to build a building. The builders are from out of town, so they won't deposit in the bank. All the people of town deposited 1,000 gold pieces in my bank, which is the liability. On the asset side, I have the gold pieces in my vault.

If everyone puts gold in the banks, what can they use to transact to buy food, pay for services, etc?

So, instead of taking some of your gold and turning it into money, why don't I just give you a note? a note that says, "You put x amount of gold into my vault." For example, for every one gold piece, I'll print a bank note. Then I hand you a slip of paper that only I can print. Anyone who holds the piece of paper can go back to the bank and get a gold piece. So instead of using the gold piece, people will use the slip of paper. If you give me 5 gold pieces, I'll give you 5 gold pieces' worth of outstanding bank note outstanding.Not only is your gold safe now, but you also have these pieces of paper that are extremely difficult to forge and something to trade with that is simpler than gold.

Besides securing your gold, the bank is providing a unit of exchange. This looks like our money, a dollar bill. A dollar bill is a federally reserved bank note from the US. The Federal Reserve Bank is backed by US Treasury bonds.

Bank notes and checks

Let's explore the notion of using something other than actual gold as a unit of exchange.So I've built my bank using 100 gold pieces, which is my equity. One of the people in my area deposited 500 gold pieces, and I asked him, "Whether you want all of it in your checking account or some cash back?" He says, "I need some cash to transact every day to buy supplies, food, etc." So put $400 in the checking account and get $100 back. So there are 100 gold pieces left. Maybe I'll hand him $5.20 for that. These are not dollars yet. These are just my bank notes. Anybody who hands me these notes will get equivalent gold pieces. 400 gold pieces are a liability for me.

A checking account is one in which you do not earn interest on your deposits but can access them at any time.

Another person, B, deposits 200 gold pieces and wants to keep half of it in cash and half in a checking account. So let's explore how transactions are going to happen between A and B.

B has an apple, and person A wants to buy it. Person A asks how much an apple costs. Well, person B says an apple costs two gold pieces. Person A says, "Well, let me just give you the piece of paper that these banks say you can trade in gold with." So person A hands over 20 bank notes; person B hands over the apples and also hands over 18 of the 1 bank notes.

What's neat here is that no gold has to be exchanged, and you're able to be very exact with the bank notes. You couldn't break gold, but a bank could issue small denominations of gold pieces equivalences.The notes could switch among people as an economy needs this function, and the bank doesn't have to worry about anything and gold doesn't have to move around.

Assume person B is a home builder, and person A is going to hire him to build the house for 200 gold pieces. But that's a huge amount of money, and nobody likes to walk around with that much money. So how about person A writes a check to person B? A check is a note that person A writes that instructs the bank to transfer that amount of gold in my name to person B. So person B builds a house, and person A writes person B a check. B can take it to the bank, and the bank will do the transfer. The bank just has to do a little bit of paperwork. That is useful because we don't have to exchange the cash.

Giving out loans without giving out gold

So let's again start with our example. I've used 100 gold pieces to build a bank, and I have an initial capital of 200 gold pieces. So my initial equity is 300 gold pieces. So villager A comes and deposits 100 gold pieces, and I give him the checking account. Person B comes and deposits 200 gold pieces. He gets half the bank notes and half in his checking account. So I give person B $5 in bank notes.

Now let's think about what happens when we actually start to lend some money. So in our old system, if someone had a project that required 300 gold pieces, we'd actually give them 300 gold pieces, taking them out of our vaults. They would use the 300 gold pieces to hire people or purchase supplies for their project, and those people would deposit the money back into the bank.

How could we do it without having the bank give out gold?

If safety is concerned, gold is not an easy thing to transact with. So for person C, we lend him 300 gold pieces, but instead of taking it out of my assets, I can just create a checking account for him. Perhaps a combination of checking and cash He can use the cash to pay his laborers, and if they don't want to hold a piece of paper, they can get the gold in exchange for it.

Another person comes and needs 100 gold pieces to build the factory, and I can create a checking account for him. It looks like the bank is making money out of nowhere. It looks like the balance sheet is increasing infinitely. So let's say person A is the one who can build a factory. Person D hands over a check to Person A. When A takes the check that he got from D to the bank, the bank transfers all the money from D to A.

How far can this process continue? Can a bank just continue issuing loans and checking accounts indefinitely, essentially collecting the difference in interest between the interest it gets on the loan and the interest it gives on the checking account?

No, then the bank will take on arbitrary amounts of risk, and there are regulations called reserve requirements that tell us how much lending a bank can do relative to its actual reserves, though banks would do it to some extent on their own. In this case, the reserve is gold. how much checking and bank notes it can issue relative to its reserves.

Reserve ratios

In the previous example, as opposed to giving gold out to make loans and be used for the projects, gold gets redeposited and then lent out again. Every time it made a loan, which created an asset, it had a corresponding liability, which was either a checking account that the entrapreneur could use or bank notes, which are essentially cash that the entrapreneur could use to pay their labor or whatever they needed to do.

The obvious question is how much a bank could do it for. When does this stop? Can the bank just keep increasing the left and right sides of the balance sheet?

A reserve is something that you keep aside, thinking that you might need it one day. The checking account holder could come to the bank and request their gold for whatever reason. So you have to leave aside a little bit of gold just in case someone wants their gold back. The "reserve ratio" is the amount of gold that must be set aside in relation to the total amount of gold demanded. So what keeps banks from issuing more assets and debts to expand their balance sheets is a reserve ratio requirement. Bank regulators might say that your reserve requirement must be 20%.

So as long as more than 20% of checking accounts don't demand their money back, the bank's going to have "liquidity." The bank is going to be able to fulfill its promise because all of the people think that at any given moment they can go to the bank and get the gold.

Reserve ratio requirement

Let's say that in our world, the reserve ratio requirement is 10%, which means that for every dollar of checking account liabilities or note liabilities that I have outstanding, I have to keep at least 10% of that in actual reserve currency is.In our world, it's gold, but in the current world, it's dollar bills. We'll go toward dollar bills later.

Let's start our example from scratch and see how big our balance sheet can get. So my building is worth 100 gold pieces, and then I capitalize it with another 200 gold pieces. So 300 gold pieces are my equity. Let's say I make 100 gold deposits and open the checking account. This is all the reserve I have; how much can I lend out?

Well, the reserve ratio requirement says that my reserves over my total checking accounts that I have on my liabilities and the notes that I issue can be no more or have to be at least 10% of that. So right now I have 100 gold pieces in my on-demand checking account and 300 gold pieces on reserve. So there are more reserves than demand accounts because I pre-capitalized them with some of my initial equity. So how much lending can I do?

The requirements say that I can only expand the on-demand accounts so that the reserve is at least 10% of them. So 10% equals reserves plus demand deposits.

10% * demand_deposits = reserve_gold => demand_deposits = 300 * 0.1 => demand_deposits = 3000

So I can have up to 3,000 gold pieces as demand deposits.

How much can I expand my balance sheet?

Well, I can keep making loans until I have 3000 gold pieces in demand deposits. It keeps the bank liquid. Liquid means that when someone actually asks for their gold, I have the gold to give it to them.

A separate question is: Am I solvent? Solvent means: am I good for the money?

It's just an issue of whether your assets are larger than your liabilities. So if I create a checking account for 3000 gold, I'll be solvent because my asset will be 3000 + my 300 gold pieces of equity, which is greater than my liabilities. So if someone asks for 400 gold pieces, I will be solvent but have a liquidity problem if I already have 3000 gold in my checking account.

Leverage

Let's say I start off my bank again and I have 300 gold pieces of equity, used 100 for my building and 200 gold pieces in my vault to start off.I take a 100 gold pieces deposits and have an off setting checking account.I lend out some 300 gold pieces of loans to person A and gave him a checking account.I gave another 300 gold pieces of loan to person B too.

Leverage is essentially how much asset that you control with certain amount of equity.In our example our equity is equal to 300 gold pieces.So how many assets that we're controlling with that 300 gold pieces? Our assets is 1000 gold pieces.Lot's of time when people talk about leverage,you might hear 2:1 leverage.That means the ratio of asset to the equity is 2:1.In our case is 1000/300 which is 10:3.It's a fair leverage ratio.

A very good reason that a bank wants to do this is because if it's making more money on its assets than its paying on its liablities, so bank want to take as much leverage as much they want.Every time it adds some assets and some liablities, it's going to make a difference.It's going to make the spread on that money so it wants to keep doing that.

But there's a downside to leverage because what if some of the loans aren't so good?Leverage when things are good, when they go on the upside, it kind of multiplies how much money you're going to make but on the downside leverage also multiplies the loss you would take.

So what happens if I had 50% loss on the loans that I have given?In a example where assets is equal to equity, if assets go down by 50%, equity will also go down by 50%.But now if I had some leverage what happens if the value of my assets go down by 50%.So my those two loans shrinks to 50 because our assets go down by 50%.Now the total asset is 500 before it was 1000 and I have 700 of liablities.Here I have negative equity because assets = liablities + equity.So my equity is -200 so essentially I'm broke.The bank is out of business.In this situation there's a very good reason for people to get their money back because even if you gave all the time in the world, this bank is not going to be able to pay back its money.This situation is called "insolvency".Reserve ratio dealt with the illliquidity that make sure enough gold is left aside when people came to want the gold back but if by chance people ask for more gold that you had, it doesn't mean that you're out of business.You just have to tell them to wait while you deal with you assets to get those loans to be paid back.You're still solvent.

Insolvency is when you actually because of bad investments, you actually end up with less assets then you do have liablities and there's nothing left over on the equity column.That's what a leverage is a measure of because if you have really high leverage, we have 10:3 ration so 50% loss could wipe us out.If you have 10:1 leverage, then even 10% loss would wipe you out.

So leverage is a measure of how much cusion you have to take losses in the future.Another one that people use for leverage is debt to equity.

Reserve Bank

We'll deal with a world with more than one bank. Let's say we have three banks with gold as a reserve currency. Each bank will have its own outstanding bank notes.

What is the problem here? The first is that all of them might have different reserve ratios. Bank A has a reserve ratio of 8%, Bank B has a reserve ratio of 10%, and Bank C has a reserve ratio of 12%. So there's no consistent reserve ratio. Let's assume Bank C was initially built and people started depositing. Latent banking business flowed, and people also started depositing in Bank A. Maybe one day 9% of the checking accounts at Bank A will want their money back. Bank C knew 9% could happen, so that's why he kept 12%. So Bank A can't give the gold back, and that scares everyone. Everyone comes and starts withdrawing, but it's not the only bank. Everyone will have less trust in the banking system. So there are runs on all the banks.

That's unfortunate for two reasons. Bank B and Bank C were safe to begin with. Also, Bank A just needs 1% of gold, which it could borrow from other banks. Other banks could lend the money to Bank A as long as it's solvent, then have a systemic run on all banks. As a result, one weak link in the chain can break the entire chain. One irresponsible bank will create a bank run on all of them. There's a situation that we're not familiar with today but that happened many times in history where bunches of different banks each issued their own bank notes as a form of currency. So Bank A's bill should be worth less than those of Banks B and C, which is going to be a big mess for the economy for someone in a cash register to keep track of. If one bank fails, their notes are worthless, and so on. So we have another problem with inconsistent paper currency.

So what's the solution to all this?

You could regulate reserve ratios, so that's easy to do. That's just government intervention. But how can we implement the mechanism where we can prevent bank runs, especially when there's money to lend from one bank to another? And if we can use the mechanism that prevents this and provides a consistent currency, then we're all set. We can provide consistent currency if we have one bank issuing currency. So let's call that bank a "reserve bank."

The reserve bank is where all banks keep their gold reserves at the central bank, and instead of having gold reserves, each bank has checking accounts with the reserve bank. It solves the "bank run" problem because if 11% of people want their money all of a sudden, the bank will go to its reserve bank account and borrow from other players.

Now comes the note problem. So a law will be passed stating that only banks will issue bank notes, and that's the central bank. So banks might get bank notes for their reserve deposits, and the reserves of these banks will no longer become gold. It is now used as currency.

So the central bank dictates reserve ratios and prevents bank runs.

Treasury (government debt)

We'll discuss reserve banking again and extend this to the elastic money supply that can grow or contract as people need money.

Assume I have some equity, the majority of which I have initialized with gold and some of which is a building.Then I take gold deposits from the farmers after the crop has been harvested, which are the deposits of two farmers. We've learned in fractional reserve banking that I can leverage the amount of capital I have. The ratio of gold reserves to demand depositors Let's say the reserve requirement is 50%, which means my ratio of gold to demand deposit account cannot be any less than 50%. Let's say I have a total of 100 gold pieces in reserve, and I have 50 from the farmer, so I can lend out 150 more. There's another bank with the same thing.

What if, for whatever reason, your reserves fall below 50% for a short period of time?How do you get that extra gold?

If you're below 50% and another bank is above 50%, it'd be a convenient way if you could borrow from that other bank, or even better, if there's a central depository where all the gold reserves are, you could borrow directly from that central depository if there were no other bank to borrow from.

So we create a reserve bank where each bank puts its reserves, which are the assets and liabilities for this central bank and are the demand deposit accounts for the nationally chartered banks. Let's say both banks received $100 in outstanding notes for depositing $100 in gold. So the bank received a note from the Federal Reserve in exchange for depositing 100 ounces of gold, which served as their reserves.There is no longer any gold.

Even though the reserve is officially a private bank, it's setup in such a way that all of the original banks might have originally capitalized with some equity, but they really don't get any of the profits of the reserve bank. Let's say the profits from the reserve bank just go back to the government. Let's say that the board of directors is appointed by the government, let's say that.The notes are issued by this bank, but we want people to have a lot of faith in the currency because it's the currency that we use in our world.

So, in order for people to have unlimited faith in the currency, we're going to make it a government obligation that is issued by the bank. Well, that means, for whatever reason, even if the reserve bank somehow did not have the gold to back it up, it would go bankrupt. But even in that situation, the government would still be obligated to give you the gold equivalent of the notes. This gives confidence that the notes are as good as gold.

Why does it matter that the government How can you trust the government?

Well, the government can just tax people. Whether they can tax them in terms of dollars, gold, or goods and services We said it's an obligation to the government, which means if all else fails, the government is going to give you the value behind the notes.

You can almost see that the government's asset is its ability to tax people. If I'm the government and I issue these government IOUs, we'll call them Treasury bonds. These are going to be considered risk-free. Why? because they are denominated in the same currency as the economy over which this government governs. If the government borrows money from you, it gives you an IOU. How do I know that if the government gives me an IOU and I give them $100, the IOU is risk-free? Unless they start issuing an unusual number of IOUs, just because they have so much interest that they can't sustain it, they can always tax more people to get you your $100.

Open market operations

Let's review what the money supply is. When we talked about M0, which is just the gold reserves, now we're going to expand that definition a little bit. The base money supply is federal money deposits and notes. In our previous scenario, all of the federal reserve deposits had essentially been turned into notes. But the bank could have some of it in a checking account with the Federal Reserve Bank. So a federal reserve note and a federal reserve deposit account are essentially the same thing. A note is a little bit more fungible, but with a checking account, you have to do a wire transfer. This is the base money supply.

In our example, the base money supply is $200. Assume that $ equals one gold piece. M0 right now is 200. M1 is how much money people think they have in their demand deposit account. So all the deposits were in both banks. Let's say each bank has $200 due to a 50% reserve ratio. So the total amount of money people think they have in demand deposit accounts is $400. This relationship makes sense because our reserve requirement is 50%. So we can kind of assume that banks tend to get as close to their reserve requirement as they can because they don't get interest on reserves. They make interest on the loans that they make against demand accounts.

How can the economy increase or decrease the money supply?Why would you want to increase or decrease the money supply?

Let's say the economy expands and we have more goods and services to produce. Perhaps we have more laborers or innovative technology, or it is seasonal. Maybe it's the crop planting season, so a lot of farmers need their cash in order to hire people to plant the crops. So now is the time when you want more money. If you don't increase the money supply at those times when you have economic expansion because of seasonal fluctuations, money's going to be more expensive. Money getting more expensive means interest rates will go up. If money becomes too expensive for some good projects, you'd restrict economic expansion.

So there are two ways. I can set the reserve requirements to 10%, and then the banks could create more checking accounts, which is a tool for the Federal Reserve Bank, but if you think about it, what happens if we make our reserve requirement 10%? All of a sudden, all the banks will start to lend a lot more money. Think about what will happen if we raise the reserve requirement back to 50%. How would the bank with a 10% reserve get back to 50%? All of these banks would either sell their assets or unwind loans. It'd be a messy situation. It'll make lots of banks undercapitalized because most banks operate right where they need to. So you don't want to play with the reserve requirement too much.

So the only other way to increase the checking accounts is to increase the reserves in some way. How can you do that? Central bank reserves are directly backed by gold, but there's nothing to stop this bank from doing fractional reserve lending, and the central bank actually has no reserve requirement. That's because, to some degree, it can always provide liquidity because it notes the obligations of the government. So it can always tax more people to back up its loans.

What the Federal Reserve could essentially do is act as a printing press for the so-called base money supply. There are two printing presses. There's a base money printing press and then the leverage printing press. It can print some notes and buy Treasury securities. So what happens if it takes $100 bills and buys Treasury bonds? Treasure doesn't have to be issued by the government. It's bought by bunches of people around the world. I had some government IOUs that I had purchased from the government. The federal reserve has $100; they just purchased the Treasury from me. Now those printed $100 bills are treasures. What am I going to do with that $100?

Well, I'm going to deposit money in the bank. The banking system now has more dollar reserves than it can apply to its reserve ratio. It can also do $100 in lending. So now M0 goes from 200 to 300, and M1 is now $600. So just by printing money and issuing Treasury bills, the central bank is able to increase the M1 by $200.