So fractional reserve banking is simply a mix of full reserve banking and savings and loans banks. Banks keep some reserves say 10% and loan out the other 90%, then the money loaned is spent within the economy, redeposited and the process repeats.
In full-reserve banking the deposits are simply stored and not loaned out. In essence, it is more like storage than banking. No interest is paid.
For savings and loans banking, the depositor cannot withdraw his money until after a certain period of time while his money is being loaned to someone. Interest can be paid at the expense of not having access to the money.
Fractional reserve was created because there is no reason to have idle cash sitting in storage when not everyone needed to withdraw all their money at the same time.
The claim is that fractional reserve banking expands the money supply. This is technically true but only on paper. I don't believe that the price level rises. The reason that it seems as though the money supply expands is because banks pretend to have all their deposits and now there is more money in the economy because they loaned out their deposits. So if a bank had 100$ in deposits. They would loan out 90$ and pretend they had 100$ which would add up to a total of 190$. What people seem to forget is that the deposits in the banks won't be withdrawn and spent. So the money supply hasn't really expanded we're just counting the money that the banks claim to have.
You might also think that the reason the money supply expands is because money is continually loaned out and then redeposited. An example is the bank has 100$ in deposits so they loan out 90$, that money is spent then put back in the bank, so they loan out 81...etc. However, this shouldn't be inflationary because the exact same thing happens for the savings and loans banks. The only difference between savings and loans banks and fractional reserve banks is that the former tells the depositors they can't withdraw their money and the latter hopes the depositors won't withdraw all at the same time. Savings and loans banks take deposits and loan them out, those deposits are spent within the economy and then redeposited, just like for fractional reserve banking. No one claims that savings and loans banks are inflationary.
So why do people think fractional reserve is inflationary? What part of my understanding is flawed?
**The reason fractional reserve banking gets out of hand is simply because of the central banks that are a moral hazard, a "lender of last resort". This is why banking crises can occur. However, it is does not affect my claim.
thanks
Thanks! That helps a lot. You don't need a central bank at all to conduct this sort of business though. The banks are just creating their own type of money(credit). They are allowing people to bid up prices with money they create. How does credit get destroyed, allowing the money supply to shrink? What are the chain of events?
You don't need a central bank at all to conduct this sort of business though. The banks are just creating their own type of money(credit). They are allowing people to bid up prices with money they create.
How does credit get destroyed, allowing the money supply to shrink? What are the chain of events?
The bank manager starts feeling that things aren't looking so good for the future of the economy... he knows that down economy usually induces bank runs... so, he figures he better start getting his house in order ASAP because it's not all banks that fail in banking panics, just the ones that are the most over-extended (in fact, the less fractional banks actually gain business during banking panics... after all, people need somewhere to put their money after they pull out of their bank they don't trust). So, he says "No new loans to anybody with less than absolute platinum credit rating" and he starts calling in loans that have already been made, tightens bank policy on default to the tightest allowed under its contracts (no grace periods, etc.) As he does this, the total outstanding credit that the bank has extended diminishes and its reserve ratio rises.
But once the manager of Bank A starts doing this, the manager of Bank B gets nervous and realizes that maybe he needs to get his house in order, too. So he starts contracting Bank B's credit extension, as well. And then so does Bank C, Bank D, and so on until all the banks in the economy are tightening credit. But as they all start tightening credit, this causes a slowdown in investment since interest rates move up in response to the credit tightening. As investment slows, the market gets pessimistic about the future and people start pulling their money out of the market. Jobs are lost, factories closed and people start needing their savings to live off. Word gets around that Bank Z never pulled back on its credit extension and will probably collapse if there is a run on it. Customers of Bank Z begin walking then running towards Bank Z, lining up at 4am waiting for the bank to open in the morning in a mad rush to be the first to get their money out before the bank collapses. By 9:30am Bank Z is in default and closes its doors for business for good. Word of Bank Z's default spreads faster than wildfire and people begin rushing en masse to their banks, no matter who it is, to withdraw their money. Thus a banking panic is triggered by the tightening of credit.
Austrianism accepts this mainstream account of banking panics. The only difference is that mainstream economics sees the banking panic as the problem whereas Austrians see the banking panic as a healthy regulator of the banking system that keeps banks honest... the real problem is expansionary credit and the fear of panics is what keeps banks prudent in expanding credit.
Clayton -
Thats right.
When loans are not paid back. To illistrate we have to fill out the balance sheet with a section for equity.
Now this is a very rough description of what actually happens. Banks have many different accounts that they run charged off loan through but it will ultimately end up impacting equity.
THANKS SO MUCH. VERY HELPFUL. KEEP UP THE GREAT WORK! I'll have to read it over a few times to visualize it more clearly.
btw you made a typo when you wrote "Cust 3 defaults on the loan."right? Customer 2*
Ahh, I did. Corrected.
"The claim is that fractional reserve banking expands the money supply. This is technically true but only on paper. I don't believe that the price level rises."
who makes that claim?? if its money and technically true then there is more money...if "only on paper" isnt money then it isnt true. which is it??? more money or more "only on paper"-not-money???
have prices and wages risen over the last several decades? or do you consider rising prices prices that have increased in dollars but that havent risen??
No, I misunderstood how the system worked. What I realized was that banks can issue credit which in essence is really like printing money as long as it is continually recycled back into the banks.
What I meant by "only on paper" is that if a bank has 100$. It loans out 90$ but keeps 10$. Then the bank claims it has 100$. Then you could say that the money supply is 190$ when the physical money is still only 100$. However, what I realized was the bank can loan out credit because it pretends to still have 100$ even though it lent out 90$. That process does increase the amount being spent and therefore increases the price level.
Anyways, it sounds confusing but I understand.
"...since they are part of the Federal Reserve System, they ask for and receive a temporary line of credit from the Fed of $50". THEY CAN DO THAT??? The reason in this case that fractional reserve banking is inflationary is because they would be receiving a "temporary line of credit". The Federal Reserve would be expanding the money supply, not fractional reserve banking in itself. Right??"
have fractioanl reserve banks existed in the past without the central bank mechanism???
if they did did the fractional reserve banks inflate the money supply??
im not quite sure what you consider a current reserve piece of currency to be....this was told to me "
"...... jl April 24, 2010 at 11:27 am We have a fiat money system. So money is whatever the central bank declares it to be. Currency is only printed to satisfy the demands of people to hold cash OUTSIDE of banks, or for banks to have cash in their vaults. In this sense, a paper dollar is just a placeholder. An entry in a book is just as good a placeholder as a piece of paper....."
i guess a reseve can be a physical dollar bill or coin or different in on paper that doesnt circulate except in people minds.
i have asked several times if fractional resrve banking actually takes place but received two differnt answers..one said yes and one said no. so i am not sure.
if the reserve dollar can be both a paper bill and or coin and simply a bookkeeping entry then i am not sure how the fractional part occurs.
with arcane currency i guess whatever form the dollar takes and however it increases it would be inflationary...(i also asked if teh historical meaning of teh word inflation meant just an increase in the money supply). whether it causes woe as videos at mises have clainmed i am not sure and thats is wha ti have been tryin gto find out.
We have a fiat money system. So money is whatever the central bank declares it to be. Currency is only printed to satisfy the demands of people to hold cash OUTSIDE of banks, or for banks to have cash in their vaults. In this sense, a paper dollar is just a placeholder. An entry in a book is just as good a placeholder as a piece of paper.
"Bob: Comes in to Bank A to request his $100 so he can buy a lawnmower. Bank A does not have the funds on hand but, since they are part of the Federal Reserve System, they ask for and receive a temporary line of credit from the Fed of $50, with which they pay Bob. Bob immediately goes out and buys his lawnmower.
There is now really $150 in existence where there had been only $100 before. This can be seen because Alice has purchased fertilizer with the $50 loan and Bob buys his lawnmower immediately. This would not have been possible in the full-reserve system where the money on loan must first be repaid before it can be spent to buy anything else."
is any part of this fractional reserve banking at all??
by saying there are $150 does are 50 of the $ in a differnt form than the other 100 of teh $ ???
did 50 $ come into teh economy in a differnt way than the previous 100 $s ?? i
No, in that case the money supply didn't expand because of credit expansion by the banks. The money supply occurred because the Fed printed. If you want to understand credit expansion you should look at Southern's diagram, it's very instructive.
@p kruger: I was giving a simplified illustration that does not even begin to explain the complexities of the ways in which money are created in the real world. In the real world, the whole process is cloaked in layers and layers of obfuscation to try to hide the essential nature of what is going on. If a layman says to Mr. Bernanke, "Does the Federal Reserve create money out of thin air?" he can respond, "No, it does not. The Federal Reserve purchases securities from the open market, backed by the full faith and credit of the United States government, and adds these as assets to its balance sheet to offset the dollars which enter the market as liabilities on the Federal Reserve balance sheet. If the Federal Reserve simply printed money out of thin air, we would not bother purchasing US government securities or any other asset as reserve backing for the money that enters the economy issued for the purpose of adding these assets to our balance sheet." If the layman was exceptionally well-educated on the intricacies of the Federal Reserve, his eyes might not yet have glazed over. If he proceed to ask Mr. Bernanke whether or not the issuance of securities by the US government was inflationary, Mr. Bernanke could respond, "There is no necessary connection between the issuance of US government securities and inflation. You can go back and look at the historical CPI and the issuance of new government securities has often corresponded with times of decreasing CPI (deflation)."
By making the system so complex, there is always an answer that "honestly" avoids the question. Look at Mr. Bernanke's demeanor during questioning by the House Banking Committee (by Ron Paul, in particular). No one could be more furtive, honest and straightforward. Mr. Bernanke even goes so far as to admit that inflation is indeed a surreptitious tax that hurts the poor the most. But he would categorically deny that the Federal Reserve is responsible for inflation, in fact, quite the opposite, one of the jobs of the Federal Reserve is to combat inflation and its use of open market operations - even quantitative easing - are all done to accomplish this very thing. As with the Lord, the ways of the Federal Reserve are mysterious, however. Quantitative easing is a euphemism for "printing money like a march hare" but this is done to promote stability by preventing deflation, not to cause inflation. When the Federal Reserve determines that we are no longer in danger of deflation, it will end QE and will begin raising interest rates in order to prevent inflation! My, what great guardians of the national money we have! Three cheers for the Federal Reserve!
By making the system so complex, there is always an answer that "honestly" avoids the question. Look at Mr. Bernanke's demeanor during questioning by the House Banking Committee (by Ron Paul, in particular).
In the context of the current banking system in place and power that the fed weilds over the economy it may be a good thing the the chairman is cryptic. Considering that alluding to certain policies or admitting certain truths can cause dramatic shifts in the economy.
Of course, this is just another arguement to end the fed.
PS. I also think that they genuinely believe that what they are doing to good and neccessary. (have to break a few eggs to make an omelet mentality) I dont think the motivation is to get over on people.
"But you're missing the point... the money has been withdrawn and spent and all that is left at the bank are ledger entries or paper notes that give individuals the illusion that they have gold in the bank when, in reality, the gold is out there being spent and driving up prices (inflation)."
is it both the lent gold and and the ledger-entries/paper-notes that are out there bidding up prices??
which all perpetuated the bubble.
is a bubble as you call it produced by inflation??
if teh federal reserve were abolished how would paper dolalrs and currency be created??
would teh treasury just print them directly to meet some type of reserve issues with individual banks??
would this in itself with existing paper cash requirments jsut keep teh same level of dollar inflation occurring with banks lending to banks directly without a fed but there own networks??
the current deposit insurance schemes are separate from the federal reserve right???
is ther feds mission to combat price inflation or monetary inflation???