How Banks Turn Trust into Cash
The economics of deposits, loans, and the money multiplier
You may have heard a variation of this story before:
Alice, an author, deposits a $100 check she received as an advance for her next book in the bank. Brandon Baker takes that $100 out as a loan from the bank to buy flour for his bakery from Mary Miller. Mary takes the money, and pays Frank Farmer for what she owes him for the wheat. Frank then takes the hundred dollars, and pays Mike the mechanic for what he owes him for repairing his tractor. Then Mike takes the money, and pays $100 he owes Brandon for catering for Mike’s wife’s birthday party the week before. Brandon takes the hundred dollars to the bank and settles his loan. Finally, Alice decides she wants to have the cash in hand after all. So, she withdraws her hundred dollars, which she receives in the form of the bill Brandon just used to pay off his debt. She promptly puts it under her mattress.
In the end, the bank and Alice’s balances are exactly as in the beginning, but everyone else’s debts, 400 dollars’ worth of economic activity, are settled thanks to Alice’s $100 initial deposit which she withdrew shortly after.
Usually, this anecdote is told with the implication that there is something rather suspect with banks.
If you ever said, or heard someone say, that there is money burning a hole in your pocket, you can relate to concept of the velocity of money. As you probably gathered from the story above, the more times the same money gets spent within an economy, the higher its velocity.
For the mathematically inclined. Otherwise, safe to skip:
V = (P x Q) / M
V = Velocity
P = Price level
Q = Real economic output, so P x Q = Nominal GDP
M = Money in circulation
The velocity of money depends on several factors:
- Interest rates: The higher they are, the more people want to save, or not spend, so velocity goes down.
- Inflation: The faster money loses value, the faster people want to spend it.
- Trust in the economy: The more confidence they have in the economy, the more people and businesses are willing to part with their money. We will come…