Fractional reserve banking - The money multiplier

Origin of the Banking System

Prior to the 1800s, savers looking to keep their valuables in safekeeping depositories deposited gold and silver coins at goldsmiths, receiving in turn a note for their deposit . Once these notes became a trusted medium of exchange an early form of paper money was born, in the form.



As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. The goldsmiths change from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional reserve banking was born.



However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.

The Fractional reserve banking

Fractional reserve banking is the banking practice in which a bank lends out most of the funds deposited and keeps the remaining fraction in reserve (as cash and other highly liquid assets), while simultaneously maintaining the obligation to redeem all deposits upon demand. Fractional reserve banking necessarily occurs when banks lend out funds received from deposit accounts, and is practiced by all modern commercial banks.

Repeated bank failures and financial crises led to the creation of central banks – public (government) or privately owned institutions that regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if a bank is low on liquidity. The emergence of central banks mitigated the dangers associated with fractional reserve banking.


Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.

The money multiplier

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.


In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money.


For example, the reserve ratio of 10 % can be expressed as a fraction:


reserve ratio = 1 / 10 = 0.1


So then the money multiplier, will be calculated as follow:


money multiplier = 1 / 0.1 = 10

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to. For instance, in this case, the bank can lend 90 monetary units for each 100 monetary units deposited, while keeping 10 monetary units as a reserve. Only 10% of the deposited money should be kept by the bank, and on lending these 90 monetary units to another bank, the process start over again.

In conclusion

The creation of money out of nothing by banks, allowed by the fractional reserve banking , increases the money supply of a country. According to the quantity theory of money, this larger money supply leads to more money 'chasing' the same amount of goods, which leads to a higher price level. It is the major cause of the inflation (see Inflation - Your money's worst enemy).

Since the amount kept in reserve by the bank is so small compared to the lended amount, the net effect is to artificially expand the money supply far beyond what physically exists. Today, more than 90 percent of the money in circulation is “credit” or money that originated as part of a debt transaction and exists only as numbers associated with an account.

So, what do you think about this? Please, leave your comments.

Deficit - What does that mean?

The Latin word deficit means deficiency and has other definitions, e.g.:

1. The general approach:

• Inadequacy or insufficiency: a deficit in grain production.
• A deficiency or impairment in mental or physical functioning.
• An unfavorable condition or position; a disadvantage.

2. The financial approach:

• The amount by which a sum of money falls short of the required or expected amount; a shortage: large budget deficits.
• A business loss.

What Does Deficit Mean Financially

Talking in financial terms, deficit means a situation in which liabilities exceed assets, expenditures exceed income, imports exceed exports, or losses exceed profits .
A deficit is the opposite of a surplus (superavit). If a country imports more than it exports, it is said to have a trade deficit.

Primary Deficit and Total Deficit

The Primary Deficit is the result of government revenue minus expenses, excluding debts interest payments. Roughly speaking, it is the government's cash generation.

The Total Deficit is equivalent to raising taxes minus expenses, including debt interest. It is far more complete, since the number represents the total borrowing of the public sector.

Trade Deficit

The Trade Deficit — the excess of imports over exports — has a direct and serious effect on the value of country money. As long a country continue having big trade deficits, it means spending more money outside the country than making at home.
For instance, If your family spends $3,000 for every $1,500 you bring home, something eventually gives way.
So, likewise, If the government's deficit wasn't well managed it might lead to catastrophic consequences.

The government deficit is good or bad?

If the government borrows (runs a deficit) to deal with a severe recession (or depression), to help self-defense, or spends on public investment (in infrastructure, education etc.), the vast majority of economists would agree that the deficit is bearable, beneficial, and even necessary.
On the other hand, if the deficit finances wasteful expenditure or current consumption, most would recommend tax cuts to stimulate private investment as a way to balance the budget.

United States deficit or surplus percentage 1901 to 2006

The Deficit Snowball

Each year, the deficit is added to the government debt. The Treasury, to raise the money to cover the deficit, must sell Treasury bonds.
Treasury bonds are a marketable, fixed-interest government debt security that make interest payments semi-annually.
This is known as the public debt, since these bonds are sold to the public.

The government debit, plus the interest rates, should be paid someday and the taxpayers will do so. They will have to pay higher taxes to pay the interest on the debt.
Treasury bonds mean the taxpayer's promise to pay the bills. If there's too much debt, the taxpayers might become incapable to do so and this will lead to the bankruptcy.

In conclusion

Deficit is not necessarily good or bad!
Deficit intrinsically implies in debt, and debt is like double-edged sword. It can either save you or hurt you.

The real challenge is learning how to deem which debt makes sense and which does not, and, then, wisely managing the money you do borrow. Avoiding debt isn't always smart because it could mean cleaning out your precious cash reserves if an emergency arises.

How inflation erodes your investments

What is Inflation?

The economic concept of inflation can be defined as the devaluation of the currency that causes a rise in the general level of prices of goods and services in an economy over a period of time (see Inflation - Your money's worst enemy).

Due to the huge inflation, the Zimbabwe's bill below can not even buy a donut!

How can Inflation affect me?

The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending power over time. Inflation also tells investors exactly how much of a return (%) their investments need to make for them to not to lose money on an investment

Suppose you can buy a good for $10 today and inflation rate is 5% an year. Theoretically, 5% inflation means that next year the same good will cost 5% more, or $10.50.

Regarding your investments, if the inflation rate it's not considered, your rate of return is a nominal rate of return and not the real rate of return.

The Real Rate Of Return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time.

For example, if you invest in a fund that pays you interest of 5% per year and the inflation rate is currently 3% per year, then the real return on your savings today would be 2%. In other words, even though the nominal rate of return on your savings is 5%, the real rate of return is only 2%, which means that the real value of your savings only increases by 2% during a one-year period.

Let's follow the example:

You could calculate the return from $10,000 invested at a nominal interest rate of 10%, with a real interest rate of 7%, accounting for inflation, for 20 years with interest compounded annually, using this formula:

Future value (FV) = 10,000 x (1 + rate of return) ^ period of time

Using the nominal rate of return you'll get:

FV = 10,000 x (1 + 0.1) ^ 20 = 67.275,00

Using the real rate of return, i.e. accounting inflation, you'll get:

FV = 10,000 x (1 + 0.07) ^ 20 = 38.697,00

A very meaningful difference, isn’t it? So, whenever choosing investments it would be wise to always consider inflation and determining the real return rate your investment will have.

In conclusion

If the inflation rate is significant, your investments return rates will be smaller than the announced nominal interest rates. Savers will lose out if nominal interest rates are lower than inflation rate.

As inflation erodes your investments, you should consider it when decide between investments options since there is a meaningful difference between real and nominal return rates!

Inflation - Your money's worst enemy

What is Inflation?

The economic concept of inflation can be defined as the devaluation of the currency that causes a rise in the general level of prices of goods and services in an economy over a period of time.
The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.

When the currency devaluates, the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy (the currency).

With the prices rising, a currency bill buys less each year; in other words, when inflation is present, your money is worth less and less...

The magnitude of inflation - the inflation rate - is usually reported as the annualized percentage growth of some broad index of money prices.

United States historical inflation rate

How Inflation works?

Increases in the quantity of money or in the overall money supply (or debasement of the means of exchange) have occurred in many different societies throughout history, changing with different forms of money used.

For instance, when gold was used as currency (see The Gold Standard - Money versus Currency), the government could collect gold coins, melt them down, mix them with other metals such as silver, copper or lead, and reissue them at the same nominal value. By doing this, the government could issue more coins without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the consequence is inflation.

This practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes less, consumers would need to give more coins in exchange for the same goods and services as before. These goods and services would experience a price increase as the value of each coin is reduced.

The adoption of fiat currency (paper money) (see The Gold Standard - Money versus Currency) by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money have taken place in a number of countries, producing hyperinflations - episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money. The hyperinflation suffered by the Weimar Republic of Germany is a notable example.

How you are affected by inflation?

It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income.

Your investments could be seriously affected by the inflation (see How inflation erodes your investments). Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%.

In conclusion

Inflation is entirely and only due to an increase in the money supply in the economy and the prices will rise as an inevitable consequence of inflation.

The main consequences of high inflation are:

• Increase in the cost of living;
  
• Low levels of domestic and foreign investments due to the economic and political instability;
  
• Savings will be discouraged since the real value of savings declines;
  
• Long-term investments will be discouraged;
  
• Real wages fall sharply;

The Gold Standard - Money versus Currency

Before money shows up

Since the beginning, our society felt the need of a way to exchange resources. The Barter probably was the first founded solution to exchange of resources or services for mutual advantage.

From 9000-6000 B.C., livestock was often used as an unit of exchange. Later, as agriculture developed, people used crops for barter.

Bartering has several problems, most notably the coincidence of wants problem. If a wheat farmer needs what a fruit farmer produces, a direct swap is impossible as seasonal fruit would spoil before the grain harvest. A solution is to trade fruit for wheat indirectly through a third, "intermediate", commodity, this way, the intermediate commodity money makes the market more liquid.

The writing, invented in Mesopotamia about 3100 B.C., had its main use, and probable motivation for its development, for keeping accounts of the exchanges made between people.

Stamped money

The first stamped Money was an Electrum (naturally occurring alloy of gold and silver) stater of a lion's head, coined at area of Lydia, and date about 610 - 560 B.C.

Although gold and silver were commonly used to mint coins, other metals could be used. For instance, ancient Sparta minted coins from iron to discourage its citizens from engaging in foreign trade.

An important effect of coins was that governments now controlled the release of money into the market. They could also manipulate the money supply. This was done by various Roman emperors, who would reduce the precious metal content of Roman coins when they needed money.

The birth of Banking

The Banking concept was originated in Babylonia about 3000 B.C., due the activities of temples and palaces which provided safe places for the storage of valuables.

By the sixteenth century a new form of money had appeared. Instead of taking the form of gold or silver coins, the new money comprised promises written on pieces of paper.

The money changers of the time were the goldsmiths, they had the premises and equipment necessary for working with precious metals. So began the practice of storing gold for other people, a service for which the goldsmith would charge a fee; the foundation of our modern banking system.

The Gold Standard

The Gold Standard is a monetary system in which the standard economic unit of account is a fixed weight of gold.
Under this kind of system, the money is said to be "backed by gold" and national money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price.

After the extinction of the gold standard, the governments could print as much money as it wanted because the money was no longer regulated by gold, thereby making it a Currency, and there is a huge difference between money and currency.

The Fiat money

Enters the scene the Fiat money. Fiat money refers to money that is not backed by reserves of another commodity.

The term derives from the Latin fiat, meaning "let it be done", as the money is established by government decree. Where fiat money (money that is intrinsically useless; is used only as a medium of exchange) is used as currency, the term fiat currency is used. Today, most national currencies are fiat currencies, including the US dollar, the euro and all other reserve currencies, and have been since the Nixon Shock of 1971.

Almost every country is on a system of fiat money. The value of money is set by the supply and demand for money and for other goods and services in the economy. The prices for those goods and services, including gold and silver, are allowed to fluctuate based on market forces.

So the government is free to produce their own money in any amount desired. When government produces money more rapidly than economic growth, the money supply overtakes economic value. This drives to a economic phenomena called Inflation (see How inflation erodes your investments).

Therefore, it is not surprising that the intrinsic value of gold has risen so much since then, as we can see below:

In conclusion

Money have a real intrinsic value, i.e., can be exchanged, at any time, by the commodity by which it is backed - such as gold, silver or precious stones.

Currency, that have no real value, is a form commonly acceptable as a medium of exchange. Since it is not backed by anything, its value is based in its ability to be circulated or be accepted by people.

Dividend yield

What is Dividend Yield?

If you are a value investor or looking for dividend income then there are a couple of measurements that are specific to you. For dividend investors, one of the telling metrics is Dividend Yield.

Historically, a higher dividend yield has been considered to be desirable among investors. A high dividend yield can be considered to be evidence that a stock is under priced or that the company has fallen on hard times and future dividends will not be as high as previous ones. Similarly a low dividend yield can be considered evidence that the stock is overpriced or that future dividends might be higher.

Dividend yield is an easy way to compare the relative attractiveness of various dividend-paying stocks.

This measurement is a financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock.

In others words, dividend yield tells you what percentage return a company pays out to shareholders in the form of dividends. It is known that older, well-established companies tend to payout a higher percentage then do younger companies and their dividend history can be more consistent.

How it is calculated?

You can calculate the Dividend Yield by taking the annual dividend per share and divide by the stock’s price:

dy = annual dividends per share / price per share

To better explain the concept, refer to this dividend yield example:


Two companies both pay annual dividends of $2 per share.

The XPTO company's stock is trading at $20. So, the XPTO's dividend yield is:

dv = 2 / 20 = 0.1 (10%)

The ACME company's stock is trading at $25. So, the ACME's dividend yield is:

dv = 2 / 25 = 0.08 (8%)

Thus, the stocks from company XPTO, that pays the highest dividend yields, would be preferable, but, care is needed when assessing this indicator, because as the share price is in the denominator, the dividend yield may seem high if the stock price is too low. What actually may reflect some kind of problem with the company instead a good policy to pay dividends.

It should be noted that companies do not announce a dividend yield per se, but rather a total dividend per share, the yield then being calculated from the current share price.

Thus, a company with a particularly volatile stock price may see drastic swings in dividend yield despite a consistent dividend. As such, an increasing dividend yield over some period of time (quarterly, annually, etc.) while the dividend itself remains stable is often considered a sign of an artificially low (i.e. undervalued) stock price.

In conclusion

Dividend yields is an useful tool to help you pick some good stocks and build a effective portfolio. But it shouldn't be used as an unique parameter to pick stock.

It would be much wiser to use it combined with others analisys tools and techniques.

Exponential growth applied to your investments

What is Exponential Growth?

Most people can’t realize the effects of the exponential growth.

To do so, it’s necessary to understand correctly how it works.
Theoretically, it occurs when the growth rate of a mathematical function is proportional to the function's current value. Sometimes it is called geometric growth.

Some real examples are:

• The number of microorganisms in a culture broth will grow exponentially.
• A virus typically will spread exponentially at first.
• Human population, if the number of births and deaths per year were to remain at current levels.
• Compound interest at a constant interest rate provides exponential growth of the capital.

Regarding the compound interest, that is closely related to the exponential growth, Albert Einstein, fascinated with its mathematical implications, is quoted as saying: "It is the greatest mathematical discovery of all time." And if it’s used correctly could be the greatest discovery to your investments.

Let’s focus in a fictitious investment case.
If 100,000.00 of a monetary units were invested in a fund earning 12,68% a year (1% a month) - considering a nominal rate of return * - let’s say, by ten years, we’ll have the following growth.

* We had already learned about nominal and real return rates in How inflation erodes your investments

Nothing really impressive, isn’t it? The initial investment growth looks like a straight line (arithmetic growth) not an exponential.

The graph above shows an inexpressive progress on our investment. From this perspective, we aren't getting anywhere. But if we truly understand the potential of exponential growth, we could realize that the results were just beginning to show up.
Most of the time we can barely understand the exponential growth practical implications; its frequently is not completely understood by our common sense.

Exponential growth's implications

The following exponential story can illustrated it clearly:

A courtier presented the Persian king with a beautiful, hand-made chessboard (A chessboard have 64 squares, 32 black and 32 white).
The king asked what he would like in return for his gift and the courtier surprised the king by asking for one grain of rice on the first square, two grains on the second, four grains on the third etc. (an exponential growth). The king readily agreed and asked for the rice to be brought.
All went well at first, but the requirement demanded over a million grains on the 21st square, more than a trillion on the 41st and there simply was not enough rice in the whole world for the final squares.

On the entire chessboard there would be necessary a heap of rice larger than mount Everest!

The exponential growth is characterized by an accelerated upward curve like a population size graph below:

The real results of exponential growth applied to our investments can be noted if we analyze the results on a more wide period of time. Let’s see the evolution of our investment for a 30 years period with the same interest rate:

Pretty cool! If we invest 100,000,00 monetary units for 30 years with an interest rate of 12.68% a year, we’ll end up with almost 4 million.

In conclusion

For most people, the 30 years period of time to keep money invest it’s not practical at all.
But think about your kids, or in yourself if you are young enough. You could ensure a peaceful future for your children using the power of exponential growth.