“For tonight’s entertainment, the Big Boy is going to show you some magic!”
“There it is! He puts one hundred dollars in his hat, and……” “POOM!” “Now there are five hundred dollars!”
What if I told you the Big Boys in the Finance world can actually create money out of thin air? Would you be even more surprised if I told you that they do it for us? What is Big Boys’ method?
Name of the trick is “Money Multiplier.”
All the macroeconomics students should know this term and how to do the calculations associated with it. But do you know what it really means and why it works?
So the money multiplier has to do with the most fundamental institutions of finance: banks. We all know how banks work. People who have savings put their money in the banks to gain interest and people who need money borrow money from the banks and later pay back with interest. However, banks cannot lend out all of the money in its vault because if they don’t have any money at their hands, their customers won’t be able to make a withdrawal. And the bank is pronounced insolvent. (For a better definition of Insolvency click here, or contact me.) So the Federal Reserve, the central banking system, sets a standard percentage of assets for all the banks to keep as reserves, money that is not to be loaned out. The percentage is called Reserve Ratio, and the ratio is currently at 10%.
Suppose T. John Baird has 10,000 dollars he wants to save and he puts them in Bank of America. Bank of America puts 1,000 dollars as their reserve as required and now has 9,000 dollars to lend out. Randy decides he loves marshmallows and wants to own a marshmallow factory, but he is 9,000 dollars short to start the firm. So he goes to Bank of America to borrow 9,000 dollars. When he gets the money, he purchases all the equipments he needs for the factories from Ronnie. Then, Randy gets the marshmallow machines and Ronnie gets the 9,000 dollars. Ronnie puts his 9,000 in Citizens Bank. Citizens Bank puts 900 dollars as reserve and lends out 8100 dollars to Razor. Razor purchases lots of razors from Ronda and Ronda saves the 8100 dollars in Sovereign Bank…
Do we see a pattern here? Note that T. John Baird still has his 10,000 dollars in the bank creating interests for him, but Randy now has marshmallow machines and Razor has razors. Or you could say that Ronnie now has 9000 dollars and Ronda 8100, because they are of the same value as the marshmallow machines and razors. So up to this point, the 10,000 dollars from T. John Baird has already generated 17,100 dollars, which couldn’t have happened if T. John Baird decided to hide his money under his mattress. The process through which these values are generated is what we call the money multiplier. And when Sovereign Bank lends out Ronda’s 8100 dollars, even more money will be created… but how much Exactly?
Here’s a little math: 10,000+9000+8100+7290+6561+……=10,000x(0.9)^0+10,000x(0.9)^1+10,000x(0.9)^2+10,000x(0.9)^3+…..= 10,000 x 1/(1-0.9)=10,000 x 10= 100,000 (See how the formula comes to be from here, or take Calculus 2, or contact me)
Doesn’t matter if you understand the math, but do remember the conclusion: This formula calculates the money generated by the money multiplier. Total Deposits represents the money generated by T. John Baird’s saving, and the Initial Deposit would be the 10,000 dollar saving.
Smart as you are, you must have realized that the money multiplier doesn’t actually help anybody become rich directly because Randy still owes Bank of America 9,000 dollars and Razor still owes Citizens State Bank 8,100 dollars. And you are a hundred percent correct, because money multiplier only generates money, not wealth. Wealth is defined as the difference between what one owns and what one owes.
However, the money multiplier does give people opportunities to use borrowed money to make profits and create economic and social values. Randy would never be the owner of the largest marshmallow company that he will be if he didn’t have that 9,000 dollars. And Razor would never be the chief designer for Gillette if he didn’t have that 8,100 dollars.
Is the money multiplier perfect though? Think about it. Maybe next time you can show off to people by explaining why the financial crisis in 2008 happened using some of the things learned today.