Monday, April 11, 2011

CHAPTER 15: Surprisingly enough macroeconomic planning started with an enterprising goldsmith.  Let's call him Mr.Locks  (you may have heard of his daughter Goldie).

Mr. Locks was an artisan who fashioned things out of gold.

He had a secure storage facilty for all that valuable gold.

One day someone came to him and asked him if he would store their gold in a safe place for a fee.  He said yes and that is how Mr. Locks became a banker. 

He gave the person a warehouse receipt for the gold he had in storage.

Over time Mr. Locks noticed something rather odd.  Most of the gold was staying in his storage facility.  Instead of taking gold out people would just sign over their warehouse receipts which therefore became money.

The receipts were money because they were backed by gold which was the real money.

Then Mr. Locks had a bright idea.  If only say 25 percent of the deposited gold was ever demanded for delivery why not create some more warehouse receipts and "lend" them out for an interest payment.  Now let's see.  How many can I create? 

After doing some calculations he came up with the formula 1/r where r is the ratio of gold on deposit to warehouse receipts.  In this case r is 25/100.  1/r is 100/25 or 4.  Economists call this the MONEY MULTIPLIER.  Stay with me here.

Since 1000 dollars of warehouse receipts was already out there, Mr Locks decided he could create 3000 more and still have enough gold to back the claims on his gold  (1000/(1000 + 3000) = 25 percent.  And thus the principle of FRACTIONAL RESERVE BANKING was born.

Review Questions:    Isn't fractional reserve banking fraudulent since more than one claim is issued on the same asset?

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