Thursday, February 2, 2012

Pumping Money into the Economy

A simple story of paper money goes something like this. A guy named Pete has a big bag of gold and he is afraid that someone is going to steal it. Pete is not alone. There are many people who don't like to keep their gold coins underneath their beds. Someone sees a business opportunity in this predicament and decides to set up an institution where Pete and others can deposit their savings. This "bank" charges Pete a small fee for the service. In return, the bank issues Pete a slip of paper that indicates how much gold is due to him. Pete is happy with this situation. Then one day Pete decides that he needs to buy a new wagon. Pete agrees to pay the owner of the wagon one bag of gold. Instead of going down to the bank and using his slip of paper to withdraw his coins, the owner of the wagon tells Pete that he will accept the slip of paper as payment.

The bank begins to realize that few people actually demand the bags of gold anymore; they just pass around the pieces of paper. The bank calculates that, on average, only about 20% of the gold is actually withdrawn each year. The bankers, seeking more revenue, decide to loan pieces of paper to people and charge those people interest. The total amount of paper money in circulation is now greater than the amount of gold at the bank. For a while, this is no problem. The bankers make a profit and ordinary people are able to borow money and don't have to worry about safeguarding heavy bags of gold. As time goes by, though, people start to realize that there are lot of those pieces of paper going around. In fact, prices of almost everything in the town have gone up because the bank is basically lending money to anyone who wants a loan. People start a run on the bank. The bank isn't able to pay all the gold demanded! The paper becomes worthless.