What is the difference between money multiplication and velocity of money?

Discussion in 'Economics' started by strantor, Dec 28, 2011.

  1. strantor


    I have been in a debate online and I don't fully understand what I'm talking about. I have been trying to convey the point that banks loaning out money creates money that didn't previously exist into the economy (money multiplication) and I keep being told that the new money is just an illusion attributed to velocity of money.

    consider my example, as I posted it:
    The banks don't print money, true. But they do create money in the form of loans. Let's say that you are a brand new bank's only customer. you deposit for example 10,000$ in your account; the bank is allowed to loan out 9000$ of that money. That's their fractional reserve limit, 10%. So, you hold 10,000$ in your hand, you walk into the bank and hand it over. Now you walk out with a debit card. The debit card is as good as the bills that you walked in with; it is money. So joe blow walks into the bank right after you leave and asks for a car loan; the bank says "sure joe, we can loan you up to 9000$" - Joe agrees, and walks out with a bank check for 9000$. So now your 10,000$ just turned into 19,000$. Now, TECHNICALLY, the 9000$ doesn't exist, because when joe signed on the line, his promisory note became a negative number in the bank's books. If the auditor came around and looked at their books, the auditor would see that they had the promisory note, which is just as good as money also. the bank traded your 9000$ for a promisory note valued at 9000$, no harm, no foul. But the fact that the 9000$ doesn't TECHNICALLY exist (because it is cancelled out in the bank's books by the promisory note), doesn't matter to the economy. The promisory note only exists in a filing cabinet down at the bank. it does not exist out there in the economy. Out there in the economy, there is IN FACT 9000$ more than there was 10 minutes ago. The bank created it. Now, here's the kicker. Joe blow goes down to the dealership and hands the check over Jim Bob the car dealer for a used mustang. Jim Bob thinks, hey, I think I'll go open an account at that new bank, they have good interest rates. So, Jim Bob walks in there 6 hours after you left and deposits the 9000$ that Joe Blow gave him. Guess what, a deposit is a deposit. They are allowed to loan out 90% of every deposit. So, now they can use Jim Bob's 9000$ deposit and loan out 8100$ of it (10%, just like before). So Jane blow is jealous of Joe's new car and decides to get her own. She walks into the bank right after Jim Bob walks out, and she takes out a loan for 8100$. So your initial deposit of 10,000$ has now turned into 27,100$. The phenomenon is called money multiplication, and the total amount of money a bank can generate from a single deposit is equal to the inverse of the reserve ratio. so if the reserve ratio is 10% and your deposit is 10,000$, then the bank can generate up to (1/10% = 10) 10X your deposit. 100,000$ from your 10,000$ created by relending 90% of every deposit that comes back. (more info here http://en.wikipedia.org/wiki/Money_multi…

    is that fiction? or is it again velocity of money?

    And now the other person's counter-example:
    It's not fiction: Money is multiplied by being reloaned - but you're seeing it in the wrong context. You think it's new money being created, but it's the same old money being spent multiple times. It is a velocity of money thing.

    Consider this scenario instead.

    Rather than you depositing your money in the bank, you buy a new kitchen from Joe Blow, and pay him $10,000

    Joe Blow then goes to Jim Bob, and buys a second hand mustang car for $10,000

    Jim Bob, rather than depositing the money in the bank, decides to go out and spend it on a new interior design, and hires Jane Blow to do it for $10,000

    Jane Blow then uses here new money to buy a second hand Toyota Prius for $10,000.

    Question. How much money has been spent in the economy?

    $10,000 new kitchen
    $10,000 on a Mustang
    $10,000 on an Interior Design
    $10,000 on a Prius.

    How much money was spent - $40,000. How much money existed? $10,000.

    I see both examples as being correct but cannot make a connection between the two. is the money multiplication and velocity of money the same thing? do the banks create money into the economy in the form of loans or not?
  2. Yes the banks do create money every-time a loan is made. there shouldn't be any debate about it. In fact Banks create the bulk of the money in our economy.

    “Of course,[banks] they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system (page 6-7). ”

    Chicago Federal Reserve

    "Banks actually create money when they lend it. Here's how it works: Most of a bank's loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank ... holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times."

    Dallas Federal Reserve


    Also when loans are paid back money is destroyed.

    "If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible -- but there it is."
    Robert Hemphill. Credit Manager, Federal Reserve Bank of Atlanta

    “Money is Created when loans are issued and Debts incurred. Money is extinguished when loans are re-paid.” -Congressional Research Service

    This is way crazy Peter Schiff. Types who scream hyperinflation alway get it wrong. The don't understand that money is not imortal it is created, circulated and destroyed.


    M1 would be considered monetary base or the money printed by the fed.

    M3 would be the broadest measurement of money. As you can see


    Fed printing was always around 0, while total money supply grew from a rate of 8% to 16%. Banks created all of the growth in money during this period.


    Fed expanded M1 to about %15 growth. Total money supply turned negative despite fed printing. De-leveraging or reducing debt is the reason money actually went down despite Quantitative easing.


    Fed prints another tranche. this time the money supply went from contraction to expansion, but only by %4. Not even close to money growth during the 06-08 period.

    Japan has been in this predicament for a decade . Firing round after round of money into the economy only to see a temporary gain in money supply be absorbed by de-leveraging

    This is why the libertarian's who scream hyperinflation every time the fed starts printing money are always made the fool. Certain activates expands money and others contract money. The two need to be netted out. Money was growing at the fastest rate during the housing boom. All this money was created by private banks. But the hyperinflation crowd never said a peep. Most of them anti gov libertarians believe private created money is superior and mums the word. The majority however, have false premise of the money system. Banks have always created the vast majority of our money yet get no blame. Unfortunately inflation is necessary in a debt based money system. Since money owed is alway greater than money available. Either the economy must grow exponential which is rare or the difference must be made up by Inflation.

    This is also why austerity does not work in the hundreds of time through out history. you reduce the level of economic activity while the debt continue to grow at exponential rates. Private debt is larger than public debt. in fact the fed measures all debt at 53 trillion. of course it can't be repaid, especially when austerity is applied. Clearly a function of compound interest.

    Money velocity simply compares the money supply to the number of transactions in a certain period. For example if the money supply is 12 trillion, and total dollar transactions during the measuring period is 24 trillion then the MV =2. It is a mathematical equation and can not increase the money supply. As a transaction increases one account and reduces another.

    The idea of a money multiplier is also wrong typically the banks create money first, then the fed creates after bank expansion.

    <iframe width="420" height="315" src="http://www.youtube.com/embed/tD7WgS3-Jf4" frameborder="0" allowfullscreen></iframe>
  3. jem


    Excellent review of one version of money. But, I always thought the idea was that money supply should match the expansion (or contraction) of the real economy... (not the govt spending part of gpd - but real productivity) Therefore, if asset prices and productivity are declining it would be appropriate to see money destroyed.

    Expanding M1 is not going to stop overpriced assets from reverting to their proper price. But, it could easily result in debasing the dollar and causing world goods like oil and gold to sky rocket.
  4. Actually Gov. spending is historically more productive then private created money with the exception of war of course. Increase in capital goods, roads, bridges etc. Private creation typical fuels stock market bubbles and housing bubbles. Asset price inflation has a faster and higher return than long term development of capital goods which is why banks tend to do the first. Even defense money is not a complete loss as it brought things the the Internet, gps and other spin off technologies which was more productive than gambling on derivatives which creates no wealth what so ever.

    Asset prices move as a function of money supply not the other way around.Productivity tends to increase with collapsing money as people get scared for their job.

    As far as your last sentence I'm not sure what you're getting at, M1 isn't allocated to oil or anything. If M1 is increasing but M3 is decreasing than a net money contraction is occurring and prices will go down. barring a "supply event" of a particular commodity.
  5. Strantor, Zeitgeist II:Addendum's first 22 minutes will explain the process of money creation as summarized by the Federal Reserve in a book published by them made to explain how money is created in a fractional reserve system.

    I don't agree with everything here, but the initial explanation is that mathematically the result is 9x any deposit, not 10x. You can use the explanation of the fractional reserve system with nearly identical explanations to what you've written visually in this video.


    <iframe width="420" height="315" src="http://www.youtube.com/embed/1gKX9TWRyfs" frameborder="0" allowfullscreen></iframe>

    The money multiplier is, in practice, an instrument of money multiplication in a fractional reserve system.

    The velocity of money is the length of time each dollar moves outside the government and returns. That is, how long does it take 1 dollar of new money to return entirely back to the government? That is the velocity of money, while the money multiplier is the money expansion mechanism and velocity refers to the amount of turnover and duration it takes for $1 of newly issued money to return entirely back to the government through taxation.
  6. government has nothing to do with velocity of money it is a simple equation

    MV =Nt/n

    Money velocity = number of transactions ( in dollar terms) divided by the money supply(dollars in the economy)

    The velocity of money (also called velocity of circulation) is the average frequency with which a unit of money is spent in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply. When the period is understood, the velocity may be presented as a pure number; otherwise it should be given as a pure number over time. In the equation of exchange, velocity of money is one of the variables claimed to determine inflation.

    If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy goods and services from each other in just three transactions over the course of a year

    Farmer spends $50 on tractor repair from mechanic.
    Mechanic buys $40 of corn from farmer.
    Mechanic spends $10 on barn cats from farmer.

    then $100 changed hands in course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent an average of twice a year, which is to say that the velocity was 2 / yr.
  7. jem


    1. Anyone who believes govt spending is more productive than private spending is coming from an entirely different school. I cite you the historical failures of socialist and communist command economies. I cite you to the failures of socialist europe. I cite you to California 20 to 40 years ago to now.

    2. Your statement regarding money supply and asset prices is far too simplistic. Assets prices have a demand function independent of money supply...

    In our current Fed type economy

    The stated goal of monetary policy is to match the money supply with the needs of the economy - with the goal of price stability.

    If the money supply is matched up correctly asset prices will go up or down based on productivity and demand. If money supply is not matched well asset prices will be effected positively or negatively.

    3. You obviously understood my point because you brought in m1 and m3. The concept being that an increase in money supply could serve to debase the dollar, even as real estate assets and and the finance sector of our economy contracts back to pre bubble levels.

    Our real estate sector will contract in real terms until it matches up with the buyer pools buying power. So you can debase the dollar and still see real estate go down. Until real salaries go up.... real property will go down. (or you could debase so much... foreigners buy up everything.)
  8. strantor


    Thanks for all the info. I'm a better armed combattant in the war on ignorance now.
  9. How would having the currency pegged to gold (or another commodity) affect the money creation/multiplication process?
  10. strantor


    interesting question. Actually this happened before at the creation of banks, when trade was in gold. Consider this hypothetical scenario:
    in a town there are 3 people, each have 100 gold coins.
    a banker somes in and offers to pay the people a percentage if they deposit their money in his bank, so they each deposit 50 coins and each recieve a bank note worth 50 coins. They then realize that it would be easier to trade amongst themselves with the bank notes instead of gold coins.
    Now Guy A goes to the bank and take out a loan. The bank gives him a 100 coin bank note in exchange for a promisory note. The promisory note only exists in the banker's files, but now in the economy there exists 100 more gold coins than there were previously. That's inflation already.
    So guy A buys a bunch of goods from Guy B, who then deposits that 100 coin bank note and the 50 coin note with the banker in exchange for a 150 coin bank note. Now the banker has even more money that he can loan out.
    So guy C goes to the banker and takes out a loan for 150 gold coins. Banker hands over a 150 coin bank note and now you have:
    Guy A: 50 coins
    Guy B: 50 coins, 150 coin note, total :200 coins
    guy C: 150 coin bank note, 50 coins: 200 coins
    Total: 450 coins
    so the total money went increased by 150 coins
    Theoretically, this extra 150 coins is cancelled out by the promisory notes on file at the bank, but that matters not to the economy. In this small example, if nobody borrowed again and the guys paid off their loans the total would go back to 300, but in reality people never stop borrowing. more people borrow every year than the year before, and it takes many tens of years to pay some loans off. So, yes, it can happen even with precious metal-back currency, and in fact it DID happen in the US back when the dollar was backed.
    #10     Jan 7, 2012