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Monday, December 13, 2010

Doesn't anyone see the problem with this equation?

Fractional-reserve banking

The different forms of money in government money supply statistics arise from the practice of fractional-reserve banking. Whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created. This new type of money is what makes up the non-M0 components in the M1-M3 statistics. In short, there are two types of money in a fractional-reserve banking system[16][17]:
central bank money (obligations of a central bank, including currency and central bank depository accounts)
commercial bank money (obligations of commercial banks, including checking accounts and savings accounts)
In the money supply statistics, central bank money is MB while the commercial bank money is divided up into the M1-M3 components. Generally, the types of commercial bank money that tend to be valued at lower amounts are classified in the narrow category of M1 while the types of commercial bank money that tend to exist in larger amounts are categorized in M2 and M3, with M3 having the largest.
In the US, reserves consist of money in Federal Reserve accounts and US currency held by banks (also known as "vault cash").[18] Currency and money in Fed accounts are interchangeable (both are obligations of the Fed.) Reserves may come from any source, including the federal funds market, deposits by the public, and borrowing from the Fed itself.[19]
A reserve requirement is a ratio a bank must maintain between deposits and reserves.[20] Reserve requirements do not apply to the amount of money a bank may lend out. The ratio that applies to bank lending is its capital requirement.[21]


Note: The examples apply when read in sequential order.
Laura has ten US $100 bills, representing $1000 in the M0 supply for the United States. (MB = $1000, M0 = $1000, M1 = $1000, M2 = $1000)
Laura burns one of her $100 bills. The US M0, and her personal net worth, just decreased by $100. (MB = $900, M0 = $900, M1 = $900, M2 = $900)
Laura takes the remaining nine bills and deposits them in her checking account at her bank. (MB = $900, M0 = 0, M1 = $900, M2 = $900)
The bank then calculates its reserve using the minimum reserve percentage given by the Fed and loans the extra money. If the minimum reserve is 10%, this means $90 will remain in the bank's reserve. The remaining $810 can only be used by the bank as credit, by lending money, but until that happens it will be part of the banks excess reserves.
The M1 money supply increased by $810 when the loan is made. M1 the money has been created. ( MB = $900 M0 = 0, M1 = $1710, M2 = $1710)
Laura writes a check for $400, check number 7771. The total M1 money supply didn't change, it includes the $400 check and the $500 left in her account. (MB = $900, M0 = 0, M1 = $1710, M2 = $1710)
Laura's check number 7771 is accidentally destroyed in the laundry. M1 and her checking account do not change, because the check is never cashed. (MB = $900, M0 = 0, M1 = $1710, M2 = $1710)
Laura writes check number 7772 for $100 to her friend Alice, and Alice deposits it into her checking account. MB does not change, it still has $900 in it, Alice's $100 and Laura's $800. (MB = $900, M0 = 0, M1 = $1710, M2 = $1710)
The bank lends Mandy the $810 credit that it has created. Mandy deposits the money in a checking account at another bank. The other bank must keep $81 as a reserve and has $729 available for loans. This creates a promise-to-pay money from a previous promise-to-pay, thus the M1 money supply is now inflated by $729. (MB = $900, M0 = 0, M1 = $2439, M2 = $2439)
Mandy's bank now lends the money to someone else who deposits it on a checking account on yet another bank, who again stores 10% as reserve and has 90% available for loans. This process repeats itself at the next bank and at the next bank and so on, until the money in the reserves backs up an M1 money supply of $9000, which is 10 times the M0 money. (MB = $900, M0 = 0, M1 = $9000, M2 = $9000)
Laura writes check number 7774 for $1000 and brings it to the bank to start a Money Market account (these do not have a credit-creating charter), M1 goes down by $1000, but M2 stays the same. This is because M2 includes the Money Market account in addition to all money counted in M1.

Source: wiki