There’s been a lot of contention and confusion in the comments about the Fractional Reserve system. This is a system under which our banking system has operated since the 1800s. It affects all of us, which is why it’s so saddening that so few people understand it. This video will look at Fractional Reserve Banking and answer the question, what DOES happen to your money when you put it in the bank? Let’s say you have $1000. What happens when it’s deposited? To see how your bank considers your $1000, we’ll use an old-fashioned method of accounting called the T-account, so called because it’s shaped like a capital T, with assets on the left, and liabilities on the right. When you deposit your $1000, the bank now has an extra $1000, so the amount gets added under assets. But to the bank, this $1000 is also a liability, since at any time you can come and get your money, or write a check, or make an ATM withdrawl. The accounting concept at play here is that liabilities ALWAYS equal assets. So, now the bank has possession of your $1000. What happens next? Well, the Federal Reserve sets something called the Reserve Requirement. If the reserve requirement is 100%, then the system is Full-Reserve Banking. This means that the bank has enough money to give to depositors even if all of them come and demand their money all at one time. That isn’t what happens. The reserve requirement is less than 100%, so we have a Fractional Reserve system. This means that a bank only has to keep a certain amount of deposits in reserve, and can loan the rest out. A typical requirement of the Fed is 10%. This means that each bank must keep 10% of every deposit and can loan the rest out. They can keep more if they want, but not less. The Fed constantly audits its member banks to make sure they don’t fall below the reserve requirement. For the purposes of this video, we’ll assume that the reserve requirement is 10% and that the banks loan out every penny they’re allowed to. So, out of your $1000, they’ll keep $100 and loan out $900. They still have the $1000 in the liabilities column. In the assets column, they still have $100 of your original money in reserve. They also have another $900 in assets, since from the bank’s perspective a loan is an asset. Both sides of the T-account are still equal, as they always should be. This is where it gets tricky. Some people say that the bank creates 10 times the money when you deposit it. That’s only sort of true, as we’ll see later; it isn’t actually what happens. What happens is that the $900 gets loaned out to someone else, who uses it to pay for whatever he wanted the loan for. Whomever he pays deposits the money in his account. It could be the same bank, or a completely different bank; either way, it’s a new deposit. So the bank gets another $900 in reserves, and also another $900 in liabilites since the new depositor can demand this money back as well. Now, both sides of our ledger have $1900, not just the original $1000. Effectively, $900 has been created out of thin air. What if both depositors demand all of their money? That’s $1900 total, and yet the bank physically has only $1000 in reserve. It can’t meet the demands of both depositors. The bank experiences a “run.” The bank then has to borrow money from other banks to cover them. If no other bank will lend to them, then the Fed steps into its role as Lender of Last Resort and lends the bank the money to cover the deposits. It was the Fed’s failure to do precisely that which turned a burst financial bubble into the Great Depression. So, $1000 has now become $1900. Since this money creation process is transparent to the individual bankers, if you ask them if they’re creating money, they’ll say no, they’re just lending out part of what is being deposited. But we can keep going with this process to create even more money. $90 of the new deposit is kept in reserve, and $810 is loaned out. Then the $810 is deposited again, and now our total is $2,710. The process keeps going, but notice that the amount gets smaller each time. Eventually, it’s going to peter out. Once all of that happens, the money on our ledger from all this fractional reserve banking will have multiplied by a factor of 1 divided by the Reserve Ratio. So with a 10% Reserve Ratio, the money multiplier will be 10 times. Our original $1000 will turn into $10,000 by the time this is all done. So, if the government runs a $100 billion deficit (low by today’s standards), the Treasury sells bonds to the Fed and the Fed increases the money in the Treasury’s account by $100 billion. Once it goes through the banking system, with banks, firms, and people like you and me taking out loans and depositing our paychecks, when it’s all said and done a total of $1 trillion will have been created essentially out of thin air. All 1 trillion of it contributes to inflation and ultimately takes the value from our paychecks, by making prices in the stores and at the gas pump higher, and from our savings, by making the dollar worth less. All so the government can spend beyond its means. That’s why inflation is a tax, and the most regressive tax at that. The government and the banks get to use the new money first, so they get its full value; by the time it trickles down to us, inflation has eaten most of its value away. Hopefully, you now understand not only the fractional reserve system, but why it’s so important to our everyday lives.