Sounds impossible but think it through!

Imagine all the banks in a country which we call Happy has $5 billion in fixed deposits. The bank keep 10% and loan out the balance of the $4.5billion. There is only $500million that is not lent out. There is a property market boom.There is a surge in property loans and $1.0 billion of new loans is needed. But the bank has only $500 million which it by law has to keep in reserves to maintain the Capital Adequacy Ratio. As all the available money has been loaned out, the banks has nothing to lend. All its $4.5 billion has already been loaned out. There is no money in the bank to lend to its new customers.

This is where the incredible magic occurs. Out of thin air, the Government provide a deposit of $1.0 billion to the bank. The bank then use this $1.0 billion deposit to lend to its new customers who needed the loans to buy property. Amazingly the bank has to pay interest to the Government for this $1.0 billion deposit which is an accounting entry created from nothing. Everyone is happy. The banks earn from the spread between what it pays the Government and what it collects in interest from its customers. Customers are happy since they are able to secure loans to buy their properties and the Government is smiling all the way to the bank earning interest from nothing!

When a recession occurs, there is too much money or liquidity and so the Government takes back its deposit and the $1.0 billion it created out of nothing is withdrawn from the market. So far so good as we are back to zero as far as money creation is concerned. This is one reason why recessions are good for they keep the money supply in balance.

But what happens if we have a boom year, year after year. In the second year, property prices rises and now customers want to borrow $2.0 billion. There is no money in the bank and so the Government repeats its miracle and deposit $2.0 billion into the banks .The banks used this money to loan to its customers. Now there is $3.0 billion of additional money in the market, money which never exists before.

If the boom continues for the third, fourth, fifth and sixth year, one can imagine how much new money is injected into the market. This huge supply of money creates inflation as with more money floating around, prices have nowhere to go but up. The money has depreciated simply because there is so much more money chasing after the same assets.

If initially in the country called Happy there is $100 billion of money. After six years, $20 billion of new money has been created. The total money supply increased from $100 billion to $120 billion. One dollar is now worth 83 cents of the one dollar six years ago. $120 billion times 0.833 is $100 billion. This is how our money gets smaller as the years go by. The main beneficiary is the Government who has created $20 billion from nothing and the citizens of Happy find after six years that their hard earned savings is now worth 17% less than before.

In a nut shell, that is how the modern economy works. The lesson is to put your money in hard assets such as gold, properties and stocks. Never leave your money in fixed deposits. The money will devalue year after year.