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Fractional Reserve Banking/ Money Multiplier

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Steve1225 posted on Fri, Dec 19 2008 9:40 PM

I took and passed a basic macroeconomic class in college that dealt with fractional reserve banking, but I forgot those falsehoods and errors and replaced them with Austrian Economics.  I am confused with fractional reserves and how it increases the money supply.  If reserve requirements are 20% and every bank has $100, then the banks will loan out $80 and only have $20 in reserves.  This is an increase in the money supply done in cartel like fashion, but this is just halting savings and increasing spending, the money supply on the street has increased or was transferred from bank vaults to peoples pockets.  The loans the bank made will be paid back with interest, increasing their supply of money, but where is money created, I see it as only being transferred.  I am aware of the malinvestment that occurs with the creation of bubbles that makes certain goods more expensive.  The only real "creation" of money, as I see it is when the Fed hands over money to the banks, the money that was "created out of thin air" as opposed to money that was already in the bank's vaults that came from savers. I am trying to find the money that truly debases the currency, the money that the Fed hands over to the banks when it buys any kind of asset, the money that is "created out of thin air."  I am confused by this:

"Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum amount of commercial bank money that can be created is $400.

For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. The deposit will always be equal to the loan plus the reserve, since the loan and reserve are created from the deposit. This is the basis for a bank's balance sheet.

The creation and destruction of commercial bank money occurs through this process. Whether it is created or destroyed depends on what direction the process moves. When loans are given out, the process moves from the top down and money is created. When loans are paid back, the process moves from the bottom to the top and commercial bank money is canceled out, effectively erasing it from existence."


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bank loans do not come from deposits.

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Answered (Not Verified) DD5 replied on Sat, Dec 20 2008 9:54 PM
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"When loans are given out, the process moves from the top down and money is created. When loans are paid back, the process moves from the bottom to the top and commercial bank money is canceled out, effectively erasing it from existence."

Anything that is paid back is immediately loaned out again.  Banks are always fully loaned up.  So this "moves from the bottom to the top" is BS because they never let that happened.  If they did, we'd have a contraction of the money supply (deflation).  God for bid we should have any of that, right?  So fractional reserve banking is only inflationary under normal operation.  Now if the central bank never printed any money, and it would let the contraction occur once the "Bust" phase of the  business cycle hits us, then we'd have a nice contraction returning to the original money supply before the boom. But that doesn't happen.  The Fed prints money and doesn't allow the contraction to occur once the "Bust" hits.



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Suggested by smokedgoldeye
Actually a 20% fractional reserve means that if a bank has 20$ it is allowed to loan 100$, creating 80$ previously unexistant dollars and increasing the money supply.
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The bank uses the money it loans to build up its reserve to 20%. If the bank has 100$ and leverages itself by a factor of 30 like certain investment banks, then it will loan 2400$ to individuals or corporations and it will loan 500$ to itself. It will add the 500$ to its reserves, increasing it to 600$ or 20% of 3000$, thereby complying with the 20% reserve requirement. The so-called reserve is just hot air because it higher than the real money that they have!

Note however that the practice of self-loaning to increase ones own reserve is illegal because it is considered too dangerous since it overstates the true reserve by a factor of 6. So how was this problem solved? Since there are multiple banks, those "self-loans" are simply renamed to interbank loans where bank A loans to its friend bank B and bank B loans the money back to bank A again, and the practice becomes legal as the negative effects of self-loanings are thought to be lost into the complex web of interbank loaning. But of course any Austrian economist knows that the whole system forms a closed loop and therefore, the only difference with the previous system is that if one bank defaults, it will take every other bank with it as well, as opposed to just itself going under.

If you are having trouble imagining how a bank with only 100$ can loan 3000$ out of thin air then picture this example: Imagine someone (call him the salesman) with a house in the woods near a lake. The saleman wants to sale that house. So he goes out and finds a rich buyer that would only use the house 2-3 days per year to head out on vacation. So the salemans sells the house to this rich person. Later, the salesman figures that he can try to sell the house again and double is money. So he goes out and finds another rich person that would only make the use of the house 3 days per year like the first one, and sells it to him also! The salesman keep doing this, all the while making lots of good money. The system works well as long as none of the rich people go on vancation during the same 3 days. But when that happens they will realize the con and will all want their money back. Of course, if anyone would try to do such a thing they would be called a criminal of the worse kind. Anyone, except the bankers that is. When the con is realized, the salesman goes to prison but the banker doesn't. He goes to washington and asks for a bailout.

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Read Ch. 4 of Juerta de Soto's "Money, Bank Credit, and Economic Cycles" --

It explains the process perfectly. 

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This Fractional Reserve business is totally confusing to me. If I deposit $1,000 to my savings account in  "Scamusgood Bank", and they use that $1,000 as a 20% reserve, then wouldn't they be able to loan out $5,000 based on my deposit? And if Scamusgood took  that fictional $5,000  they  created from my original $1,000  and deposited it in Complicity Savings Bank, would Complicity be able to loan out $25,000 using the fictional $5,000 as its 20% reserve? Where incidentally do the funds come from to repay the loans that were created out of thin air, and the INTEREST charged the borrowers? 

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The money comes from (hopefully) productive uses of the loan proceeds. For example, if I'm the one and only borrower of Scamusgood's "We've got $5,000 to Loan Out This Weekend -- Come on down!!" sale...I, being a clever, capitalist, would use that money to buy a new machine to make widgets in the half the time it usually takes me. Over the course of a year, I've will have piled up $10,000 in above usual profits. I will then go down to Mr. Scamusgood and cheefully pay him back the $5,000 plus interest. Does that make sense? Murray Rothbard has an EXCELLENT set of mp3's for sale in the store called "Economics 101" that explains how banks create money very well. Remember, the reserve ratio applies to the banks deposits (ie. their liabilities). What usually happens is that these deposits quickly disappear after a "loan sale" -- and hopefully replaced by new cash deposits. In my hypothetical case above, 1. the bank approves my $5,000 loan 2. it deposits the loan proceeds into my business checking account (The bank then has an asset of $5,000 (the promissory note I signed swearing to pay them back $5,000) and a liability of $5,000 (the balance showing in my checking account which they are obliged to hand over to me in cash whenever I want) 3. I go to the teller and ask for $5,000 in cash to spend at ACME Machine Co. for the widget machine...the money disappears from my deposit account 4. Now the bank has decreased its liabilities by $5,000...But is ALSO has to hand over to me Federal Reserve Notes (cash in the amount of $5,000). This cash would include your original $1,000 cash deposit PLUS $4,000 from Scamusgood's own account of cash (reserves) at the Federal Reserve. In the real world, lots of other people are depositing checks from other banks into Scamusgood and Fed is then depositing into Scamusgood's Fed account the net balance (which may be zero). But, in theory, if NO ONE, deposits a replacement $5,000 into Scamusgood that I withdrew, they would have BELOW THE REQUIRED RESERVE RATIO and have to call in loans "Give us back cash, please, NOW!". Hope this helps.


Bonus gift: I wrote this little story last week for my 13 & 11 year olds to help them understand the big problem with the government increasing the money supply. Hope you enjoy it.


The Three Little Pigs and the Federal Reserve Crisis

In their later years, they bought a yacht and sailed the seven seas. The three little pigs each had a bag of gold coins to spend at the various ports of call. The good life. No wolves, no Federal Reserve, no worries. Or so they thought...

One dark and stormy night, they were shipwrecked on a deserted tropical island. They spluttered ashore each with their coin purses clutched greedily...



No one came to rescue them and after some trial and some error, they had established a common sense division of labor: each pig specialized in doing one thing so their combined output was more than if each had to do everything for himself. And they were able to trade with each other using their gold coins. It wasn t what you d call the good life anymore, but it was pretty good and it worked. Here is how: One pig cut down trees and fashioned them into good square lengths of lumber stored flat in his lumber shed. He became the Lumberpig and worked day and night making one good square-cut length of lumber every month (he only had one simple stone tool). Another pig, the Fisherpig, specialized in fishing from a small raft and offering fresh seafood for sale on the beach every day before lunch and surfing all afternoon. The third pig used a small bucket that had washed ashore to go back and forth to the spring in the middle of the island to collect water for sale to his brothers. They started calling him Bucketpig, or Buck for short. Buck would often join Fisherpig in the evening for drinks and fish feasts on the beach in front of a roaring fire of lumber pieces. All work and no play made Lumberpig a dull pig although he had saved up a respectable pile of lumber. Not huge, but respectable.



Like many a businessman over drinks after work, Buck and Fisherpig would brag and tell lies to each other about the expansion plans they had and how they were going to hit it big. The truth was, they did each have a pretty good plan: Fisherpig was planning to plow his savings into new lumber to build a fishing boat with oars and a mast so he could get out to where the big hauls were. That way he could be finished getting a daily supply of fish for the island in the morning and start a tool making business on the side. For his part, Buck had in fact already drawn up plans for a simple lumber aqueduct to bring water in from the spring. He then would be free to work on his wind power idea (he was planning to stay specialized in Utilities). Each dreaming pig just needed 100 lengths of lumber. Each pig just had one problem: Lumberpig charged 1 coin per length and each pig only had about 50 coins in their piggy bank in a good month.

"Who could ever seriously save 100 coins anyway? Ah well," they each thought before going to sleep, "at least dreaming is



One evening, their stories spent, Fisherpig and Buck gazed in silence over the blue green span of the lagoon. Something caught their eye. Do you see what I see Buck? Buck was already up on his hind trotters and half-way there.

"It s a treasure box washed ashore and filled with 200 gold coins!!...If you promise not to tell Lumberpig, I ll split it with you 50/50."

"Sure. You and I have just inflated the island's money supply."

"Yeah! I just love inflation, don t you? Especially when you get the new money first and nobody else knows about it!"

They laughed and feasted deep into the night. Each secretly planning to rise early the next morning to start working on their dreams! Dreams that would unfortunately turn into nightmares because of the treasure box's evil inflation that they didn t yet understand.



Day and night weren't enough time anymore for Lumberpig to keep up his inventory levels. In the past few months both his brothers had been placing about four times the usual volume of lumber orders. More money was good all right, but what he hadn't told them was that at this rate, he was running out of lumber! He kept his lumber shed locked up and no one knew the actual respectable quantity he usually had in inventory but him. Truth was, it was normally only about 100 lengths. And as hard as he worked, he couldn't work fast enough to make more than one length a month. He was down to 20 lengths left and stared up at the ceiling at night,

"What should I do? Fisherpig and Buck are each buying about 2 lengths a month. How many surfboards and bonfires do they need? In less than six months I ll be out of stock!!" He thought of raising his prices. "Hm mm. That would stop frivolous buying wouldn t it? Then the pig who needed the lumber most would pay the higher price, right? Sounds fair and even more extra money for me would be nice. No. I can t do that. I m not a greedy pig. I ll leave my prices where they are .maybe things will work out somehow if ...but...Zzz." And he fell asleep.

Meanwhile, Buck and Fisherpig were each 40% done on their respective projects and going full steam. Little did they know, that in 5 months, Lumberpig was going to hit them with news that would have the impact of a 2x4 between the eyes.



"Sorry Buck. Sorry Fisherpig. See for yourself," Lumberpig opened the shed door wide. "The lumber is all gone. I m sold out."

"AGGHHHH!!! NO!!!" said Fisherpig. "I m ruined! I used the raft lumber in my new boat construction that is only half done! Now I have nothing to fish with to make a living!! And Lumberpig, you made it worse! Why didn't you raise your prices right away to stop one of our projects sooner -- especially Buck's harebrained water slide!! So much extra WASTE!! -- just because you couldn't bring yourself to be greedy!!!...If only that phony inflation box had never appeared!!!", he sobbed.

"I m hungry," said Buck thoughtfully. "And you know what? I screwed up too. I've built a water bridge to nowhere. And, Fisherpig, you know what s funny about all this? If we hadn't been fooled by that box of inflation, you and I could have pooled our savings and actually completed one of our projects."

There was no fire on the beach that night. Not even a meager fish dinner. And three thirsty little pigs. Later they burned the inflation box to keep warm for a while.


Rev.1 Feb.24/09

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This Fractional Reserve business is totally confusing to me. If I deposit $1,000 to my savings account in  "Scamusgood Bank", and they use that $1,000 as a 20% reserve, then wouldn't they be able to loan out $5,000 based on my deposit?

No! One bank can only lend 80% of $5,000 deposited, that is $4,000.

The  trick is that if the borrower deposits those $4,000 in another bank, that bank can lend 80% of that, i.e. $3,200 to some other client. Then there are the first $5,000 deposited in bank A, and the $4,000 deposited in bank B, and also the $3,200 which might again be increaed by being deposited in some other bank (other than bank B which has lend them). So then there will be three guys around who say that they together have "$12,200 cash on their bank accounts"... But that is not correct. They cannot withdraw all that cash at the same time because the banks together only have $5,000. And if they read their contract with their bank, it says that the bank actually doesn't need to pay back "their money"! No one has "money in the bank account". One only has a risky claim whose nominal value, i.e. best case value, is the saldo number. It's only backed up to 20%, and it's a "first come first served" system! If this circle continues all out, then the math of it is that the BANKING SYSTEM (but not one single bank) will have tunred the $5,000 into $25,000, i.e. the (maximum) multiplier effect is 1/20% = 5.

And since most money never leaves the banking system, but is only electronically transfered from the bank accounts of people and companies buying on credit to the bank accounts of sellers, this multiplier effect does get very substantial in practice.

I hope I haven't misrepresented reality here. There are details about interbanking and FED involvement and the classification of borrowers et cetera which make it more complicated. And the definitions of M0/cash and other money measures is quite confusing, I think.

Statistically, the amount of M0-money (cash) remains $5,000 all through this process though. The additional $20,000 is credit money. As long as there is no bank run or major defaults, it can be used as if it were cash money. (And if there are, then the government will transform those "bad debts" into M0-money by command anyway to save the banks...)

Btw, it's rather 5% than 20%, isn't it?

It's not fascism when the government does it.

“We must spend now as an investment for the future.” - President Obama

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