CHAPTER 16: Now let's talk about how much money Mr. Locks can create.  It depends on two things.  How much gold he has in reserve (monetary base) and what the withdrawal percentage is (r). 

An increase in gold reserves or a decrease in the withdrawal percentage would allow him to "create" more money. 

Can you calulate how much money he could create if he had 2000 dollars worth of gold and r was equal to 10 percent?

If you said 18,000 dollars go to the head of the class.  2000 x 1/r -2000 = 18,000.

Stay with me here.

Another way of looking at this is that if he creates 18,000 plus the original 2000 that makes 20,000.  10 percent of 20,000 is 2,000.  Therefore he will be able to meet the gold withdrawal requests (as long as the withdrawl ration remains at 10 percent).  A very BIG if.

Of course if people find out that all their receipts cannot be redeemed in gold he will become a very unpopular goldsmith.

Skip ahead 400 or so years.  The United States Federal Reserve is our goldsmith with a few small changes.

First money is no longer backed by gold.  That idea went out gradually but finally ended for good in August of 1971 when Nixon closed the gold window.  Funny, it seems like things have been going downhill ever since. 

People use their federal reserve notes (formerly warehouse receipts) as money because they have no other choice.  It's called FIAT MONEY and you have to take it because of the LEGAL TENDER LAW.   

Second instead of Mr. Locks determining what he thought was a safe ratio the ratio is set by the Federal Reserve.  For most banks it's now 10 percent. 

And lastly the Federal Reserve is not limited by the amount of gold in their vaults like the goldsmith was.  Imagine if Mr. Locks had the power to create gold.  He would have been a very rich man. At least until gold became worthless because there was so much of it.   

The Federal Reserve cannot only control the amount of money in the system (and therefore the price of money which is the interest rate) they can also provide money to Congress when taxes and bonds sold to the publie are not enough to finance expenditures.  This makes things like war and welfare easiser to sell to the public since no increase in taxes is required. 

Review Question:  When the Federal Reserve creates money "out of thin air" isn't that essentially the same thing as counterfeiting except that it's legal?