Unit 6 - The Production and Storage of Money, Currency, and Cryptocurrency
Learning Objective: Understand and be able to explain how money, currency, and cryptocurrency are produced and stored.
6.1 The Production of Money, Currency, and Cryptocurrency
The methods of producing money and currency vary significantly depending on its type:
- Soft Commodity Money: A farmer grows it by planting seeds and harvesting the produce (e.g., wheat, barley).
- Hard Commodity Money: A miner mines it by extracting it from the earth (e.g., gold, silver).
- Cryptocurrency: A miner mines it by validating transactions using a proof-of-work algorithm.
- Fiat Currency: A banker makes it appear magically through fractional reserve banking, often described as creating “money out of thin air.”
6.1.1 How Banks Produce Fiat Currency
Banks create money fiat currency through a process called fractional reserve banking. For every deposit made, the bank is only required to keep a small portion (a “fraction”) of the reserve deposit, lending out the rest. This allows a single deposit to magically create significantly more fiat currency in the economy.
6.1.2 Fractional Reserve Banking & The Money Multiplier
The money multiplier quantifies the new money created through fractional reserve banking. For example, if a bank’s reserve requirement is 10%, the money multiplier is 10. A $100 deposit can theoretically create $1,000 in the broader economy.
Example Calculation:
- Reserve Requirement (RR) = 10% (0.1)
- Money Multiplier (MM) = 1 / RR = 1 / 0.1 = 10
- Maximum new money created: $100 × 10 = $1,000
On page 9 of “The Story of The Federal Reserve System” the New York Fed explains how banks magically create money out of nothing:
In this example, a $100 deposit is multiplied into $1,000 through the magic of fractional reserve banking:
6.1.3 How to Calculate the Money Multiplier (MM)
MM = 1/RR where RR = Reserve Requirement
If RR is 15%, what is MM?
MM = 1/0.15
MM = 6.6666
Max amount of magic money currency created per $100 deposit: $666
If RR is 5%, what is MM?
MM = 1/0.05
MM = 20
Max amount of magic money currency created per $100 deposit: $2,000
6.1.4 Historical Reserve Requirement Ratio
From November 1980 to April 1992, the reserve requirement ratio was 12%. In May 1992, the reserve requirement ratio was lowered to 10% where it stayed until March 2020.
“As announced on March 15, 2020, the [Federal Reserve] Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.” (https://www.federalreserve.gov/monetarypolicy/reservereq.htm)
Recall the formula to calculate the money multiplier.
MM = 1/RR where RR = Reserve Requirement
If RR is 0%, what is MM?
MM = 1/0
MM = Undefined
With no reserve requirement, the potential money creation becomes undefined—an alarming reality in modern monetary systems.
6.2 What Happens When Reserve Requirements Are 0%?
If the reserve requirement is set to 0%—as it effectively is today in the U.S. (since March 26, 2020)—the formula becomes:
Money Multiplier (MM) = 1/Reserve Requirement (RR) = 1/0
Mathematically, 1 divided by 0 is undefined because division by zero approaches infinity.
What Does This Mean?
- Unlimited Money Creation
With 0% reserves, banks are no longer constrained by the amount of deposits they must hold. They can create infinite money by making loans without any reserves, as long as there is demand for loans and willing borrowers. - No Anchor to Reality
Since there’s no work or scarcity backing this money creation, it essentially allows the financial system to operate on debt and faith alone. This violates the moral foundation of money, which should require work to create value. - Hyperinflation Risk
Because money can be created out of nothing, the risk of inflation or even hyperinflation increases dramatically. This mirrors historical collapses like Weimar Germany or Zimbabwe, where excessive money creation destroyed purchasing power. - Moral Hazard
With no reserve requirements, banks are incentivized to lend recklessly, knowing they can always be bailed out by central banks printing more fiat currency. This rewards bad behavior and transfers the risks to taxpayers, savers, and future generations.
- Unlimited Money Creation
Key Takeaway
A money multiplier of 1/0 highlights the fundamental instability and infinite nature of modern fiat currency systems. It reflects a shift away from discipline, scarcity, and work-based value toward a system based purely on trust and government decree—making it unsustainable in the long run.
This also serves as a warning sign for students to critically evaluate modern monetary policies and advocate for systems grounded in work, fairness, and scarcity to preserve economic stability.
6.3 How Banks Earn Money Fiat Currency
Banks profit by lending money fiat currency at higher interest rates than they pay on deposits.
Example Scenarios:
- Loan 1: “Bank A” loans depositors money at 9% and pays depositors 0.01%. Net profit: 8.99%.
- Loan 2: “Bank B” loans “Bank C’s” money at 9% but has to pay “Bank C” 2%. Net profit: 7%.
Clearly, lending depositor money (Loan 1) is more profitable, showcasing why banks incentivize deposits. But if a bank doesn’t have sufficient reserves they can still make loans they just have to borrow from The Federal Reserve/Central Bank at the “bank rate”.
6.4 The Velocity of Money
While the money multiplier quantifies the amount of fiat currency that is created in a fractional reserve banking system, the velocity of money measures how fast fiat currency is being created and circulating throughout the economy. The Federal Reserve tracks this metric for M2 money stock. (https://fred.stlouisfed.org/series/M2V).
Observation: During recessions (e.g., COVID-19), money velocity drops significantly. How does this impact economic recovery?
6.5 The Storage of Money, Currency, and Cryptocurrency
The way we store value—whether in commodity form, fiat currency, or cryptocurrency—affects its security, accessibility, and risk exposure. This section evaluates storage methods for each type and highlights best practices for protecting your wealth.
6.5.1 Storage of Soft Commodity Money
- Examples: Wheat, barley, or rice.
- Storage Method: Silos, granaries, or climate-controlled warehouses.
Pros:
- Intrinsic Value: Can be consumed or traded directly.
- Sustains Life: Essential for survival, especially in crises.
Cons:
- Spoilage Risk: Requires careful management to avoid degradation.
- Bulkiness: Takes up significant space and requires ongoing maintenance.
- Difficult to Transport: Limited portability due to size and weight.
6.5.2 Storage of Hard Commodity Money
- Examples: Gold, silver, or platinum.
- Storage Method: Vaults, safes, or safety deposit boxes.
Pros:
- Durable: Does not degrade over time.
- Compact Storage: High value-to-weight ratio makes storage manageable.
- Inflation Hedge: Preserves purchasing power against inflation.
Cons:
- Limited Utility: Cannot be directly consumed or used outside trade.
- Portability Issues: Heavy and difficult to transport in large amounts.
- Security Concerns: Requires physical protection against theft.
6.5.3 Storage of Fiat Currency
- Examples: U.S. dollars, euros, yen.
- Storage Method: Home safes, bank accounts, or digital payment platforms.
Home Storage:
Pros:
- Avoids Bank Risks: Keeps money out of the fractional reserve system.
- Cash Budgeting: Encourages disciplined spending.
Cons:
- Theft Risk: Vulnerable to robbery without security systems.
- Limited Growth: Earns no interest and loses value due to inflation.
Bank Storage:
Pros:
- Insured Deposits: Protected up to $250,000 by FDIC (U.S.).
- Convenience: Easy access via ATMs and online banking.
Cons:
- Fractional Reserve Banking: Banks lend deposits, creating systemic risks.
- Bank Runs: Withdrawals may be limited during financial crises (e.g., Great Recession bank failures).
- Frozen Accounts: Governments can freeze funds during investigations or emergencies.
6.5.4 Storage of Cryptocurrency
Definition: Cryptocurrency is stored in crypto wallets—software programs or hardware devices that manage public and private keys for transactions.
Two Storage Options: Hot vs. Cold Wallets
6.5.4.1 Hot Storage (Online)
- Examples: Exchange wallets, mobile apps, web-based platforms.
Pros:
- User-Friendly: Access funds anytime, anywhere via the internet.
- Free or Low Cost: Most wallets don’t charge fees.
- Convenience: Integrates seamlessly with crypto exchanges for quick trades.
Cons:
- Security Risks: Vulnerable to hacking and phishing attacks due to internet connectivity.
- Regulatory Issues: Exchanges may freeze funds during legal disputes.
- Bankruptcies: Funds may be lost if exchanges collapse (e.g., Mt. Gox, FTX scandal).
6.5.4.2 Cold Storage (Offline)
- Examples: Hardware wallets (e.g., Ledger and Trezor) or paper wallets.
Pros:
- High Security: Offline storage eliminates hacking risks.
- Portability: Compact devices are easy to store or travel with.
- Autonomy: Gives full control over assets—no reliance on third parties.
Cons:
- Cost: Hardware wallets cost $79–$255, more than online wallets.
- Usability: Smaller screens and manual inputs may pose a learning curve for beginners.
- Loss or Theft: Losing the device or recovery keys means losing access to funds permanently.
6.5.6 Best Practices for Secure Storage
For Commodity Money:
- Use climate-controlled storage for soft commodities.
- Store hard commodities in insured vaults or safety deposit boxes.
- Maintain records of ownership for verification purposes.
For Fiat Currency:
- Diversify between physical cash and bank accounts to manage accessibility and risk.
- Avoid holding excessive cash, as inflation erodes its value over time.
For Cryptocurrency:
- Hot Wallet Safety Tips:
- Enable two-factor authentication (2FA) for all accounts.
- Avoid storing large balances in online wallets—use them for spending, not saving.
- Regularly update software to patch vulnerabilities.
- Cold Wallet Safety Tips:
- Use offline hardware wallets for long-term storage of large balances.
- Keep multiple backups of recovery keys in separate physical locations.
- Never share private keys or recovery phrases with anyone.
- General Crypto Security Tips:
- Regularly audit holdings to ensure balances are intact.
- Test hardware wallets periodically to confirm accessibility.
- Consider multi-signature wallets for extra protection (requires multiple approvals to access funds).
- Hot Wallet Safety Tips:
6.5.7 Final Thoughts: Why Storage Matters
The way you store your money reflects your trust in systems—whether centralized (banks) or decentralized (blockchains).
- Commodities provide intrinsic value and inflation protection.
- Fiat currency offers liquidity but depends on government trust.
- Cryptocurrencies prioritize autonomy but require secure handling due to hacking risks.
Key Takeaway:
Protecting wealth requires understanding storage methods, managing risks, and adapting strategies to evolving financial technologies. Whether storing physical gold or digital coins, informed decisions ensure security, accessibility, and stability in a changing world.
6.6 Insuring Your Fiat Currency
Bank deposits in the United States are insured by the Federal Deposit Insurance Corporation (FDIC) for commercial banks and the National Credit Union Administration (NCUA) for credit unions, both covering up to $250,000 per depositor, per institution.
6.6.1 Historical Context: Deposit Insurance and the Great Recession
Origins of Deposit Insurance:
The FDIC was created in 1933 during the Great Depression to restore confidence in the banking system after thousands of bank failures.The Great Recession (2008–2009):
During the financial crisis, the government temporarily increased deposit insurance from $100,000 to $250,000 to stabilize markets and prevent bank runs.The Deposit Insurance Fund (DIF):
- The FDIC’s Deposit Insurance Fund (DIF), which insures deposits, ran out of money due to massive bank failures.
- In 2009. the Federal Government bailed out the FDIC, which in turn bailed out the banks—effectively using taxpayer money to backstop the banking system.
Key Takeaway: Deposit insurance prevents panic withdrawals but relies heavily on government intervention during systemic crises, raising concerns about long-term sustainability.
6.6.2 The Dodd-Frank Act and Bailout Reforms
In response to the 2008 crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) aimed to prevent future taxpayer-funded bailouts by:
- Ending Bailouts: Prohibited direct government bailouts of failing banks.
- Regulation: Imposed stricter oversight, stress testing, and capital requirements to reduce systemic risks.
- Living Wills: Required banks to submit plans for orderly shutdowns in case of failure.
However, critics argue that:
- Large banks remain too big to fail, leaving the door open for indirect bailouts through mechanisms like FDIC insurance extensions or Federal Reserve liquidity programs.
- The law doesn’t fully address shadow banking systems, where non-bank financial institutions operate without equivalent oversight.
6.6.3 The 2023 Banking Crisis: A Modern Case Study
Crisis Overview:
- In March 2023, three U.S. banks collapsed in rapid succession, sparking fears of global contagion and requiring emergency intervention.
- The largest failure was Silicon Valley Bank (SVB), whose deposits were concentrated among startups and venture capital firms.
The FDIC’s Role:
- 89% of SVB’s deposits exceeded the $250,000 insurance limit—leaving most depositors exposed to potential losses.
- Declaring systemic risk, the FDIC and Federal Reserve stepped in to guarantee all deposits, including those above the insured limit, effectively bypassing Dodd-Frank’s restrictions against bailouts.
Implications:
- Moral Hazard:
- Depositors and banks may take greater risks knowing the government will intervene in a crisis.
- Erosion of Trust:
- Raises questions about fairness, as smaller institutions and individuals may not receive the same protections.
- FDIC Fund Vulnerabilities:
- Repeated interventions strain the Deposit Insurance Fund (DIF), increasing reliance on taxpayer bailouts despite regulatory reforms.
- Systemic Risk Concerns:
- Highlights ongoing weaknesses in the banking sector, particularly in managing liquidity and deposit concentration risks.
- Moral Hazard:
Key Takeaway:
Despite regulatory changes like Dodd-Frank, recent events demonstrate that systemic risks persist. While deposit insurance protects most depositors, those with balances above the insured limit remain vulnerable unless extraordinary measures are taken.
6.6.4 Lessons for Savers and Investors
- Diversify Deposits: Spread funds across multiple banks and credit unions to maximize FDIC or NCUA coverage.
- Be Aware of Limits: Know the $250,000 limit per depositor, per institution, and plan accordingly.
- Monitor Bank Health: Use bank ratings and stress test results to evaluate financial stability.
- Understand Risks of Large Deposits: Deposits exceeding the insured limits carry greater exposure during crises unless bailed out by the government.
- Explore Alternatives: Consider commodities (gold, silver) or cryptocurrencies as hedges against systemic banking risks.
6.6.5 Final Thought: Is the System Sustainable?
Deposit insurance creates confidence in the banking system, but its dependence on government bailouts raises long-term concerns about sustainability.
- With rising debt levels and inflation, the government’s ability to backstop losses may weaken in the future.
- Savers and investors must recognize the limits of the system and diversify wealth storage to reduce exposure to potential failures.
Conclusion:
The production and storage of money, currency, and cryptocurrency reveal fundamental differences in how monetary systems are created, controlled, and preserved. Commodity money—whether soft (grain) or hard (gold, silver)—derives its value from intrinsic worth and work required for production, providing a natural constraint against overproduction. Fiat currency, on the other hand, is created by decree and depends entirely on trust and confidence in government institutions and central banks.
Fractional-reserve banking amplifies fiat currency supply through credit creation, enabling economic expansion but introducing systemic risks like inflation, bank runs, and debt dependency. The ability of banks to multiply deposits highlights the illusion of abundance, where money can be conjured without real productive effort, undermining the principles of scarcity and value that define stable monetary systems.
Cryptocurrency challenges traditional systems by offering a decentralized, digital alternative that relies on blockchain technology for security, transparency, and scarcity. While crypto-assets like Bitcoin mimic the constraints of hard money, their storage methods—hot wallets for accessibility and cold wallets for security—underscore the ongoing tension between convenience and safety in modern financial systems.
Key Takeaway:
The method of money production shapes its value, stability, and risk. Commodity money requires work, fiat currency depends on confidence, and cryptocurrency leverages technology. Storage strategies further reflect the trade-offs between accessibility and security. As the world moves further into digital finance, understanding these differences is critical to assessing the trustworthiness, sustainability, and risks of modern monetary systems.