Where did the extra $100 come from?

The way our banking system works is very funny. Let me tell you a short story which will prove to you how funny it really is.

This story has 3 characters:

Character 1: Mr. Donald, a cardiologist

Character 2: Mr. Pat, a heart patient

Character 3: ABC Bank

There is a small island country which has a population of only 2 people — Donald and Pat, there is a bank in the country named ABC Bank, and there is a $100 note which is currently with Donald.

Donald goes to ABC Bank and deposits this $100. So now, Donald‘s bank account balance is $100.

Pat is a heart patient and needs to consult with a cardiologist, but he doesn’t have the money to pay fees. So he goes to ABC Bank and borrows $100. Pat promises the bank that he will repay the money in a year.

So now, the same $100 note which Donald had deposited in the bank is in the hands of Pat.

Pat visits Donald’s clinic for consultation. Donald charges a fee of $100. Pat takes out the $100 note which he borrowed from the bank and hands it over to Donald. What goes around has come around.

The next day, Donald visits ABC Bank and deposits this $100 cash into his account.

Story ends.

Now, let me ask you a question — What is Donald’s bank balance after he deposits the money? $200.

How much cash is there in the economy? — Only $100.

There is an important question we need to understand — Where did the extra $100 come from?

It simply came out of a promise made by Pat. Funny, isn’t it? This is how our banking system works; this is fractional reserve banking.

Things we own are measured in currency but that doesn’t mean there is currency backing everything we own. In fact, most of the assets we own are in the form of quantified promises made to us by other people.