Posts Tagged ‘fractional reserve banking’

363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?

Thursday, February 15th, 2007

Recently, this news report came up in CNN: Lawmaker: U.S. sent giant pallets of cash into Iraq. In this report, 363 tons of cash (worth $4 billion) were loaded into pallets and transported via military transport aircraft into Iraq ?shortly before the United States gave control back to Iraqis.? Needless to say, much of the cash went unaccounted for.

As we said before in A brief history of money and its breakdown- Part 2, when much of the world was under the gold monetary standard, nations only go off that standard under exceptional circumstances, such as war. This is because war is always prohibitively expensive and thus, can only be financed if fiat money is used. Today, we look with disbelief at such a gross abuse!

Back in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned that when money is ‘created’, the ?outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom.? Imagine what this $4 billion of cold hard cash is eventually going to do to global liquidity! To see what will become of these monies, let us examine how this massive quantity of physical cash is going to swell the total money supply, which includes bank deposits. Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let’s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%). Thus, for example, a ratio of 5% can swell the quantity of money up to the theoretical limit of 20 times.

The next question is: what is the reserve ratio? We took a look at the Federal Reserve?s requirements on reserve here. Depending on the amount on deposit, the ratio ranges from 0% to 10% (a ratio of 0% means that money can be created by the banks to a theoretical limit of infinity). Anyway, whatever the answer to this question, $4 billion of physical cash will eventually spawn many more times worth of liquidity into the financial system. It certainly would not help in the ?fight? against inflation.