Similar questions probably get asked a lot, but this one is very straightforward.
I am curious about how fractional reserve banking is inflationary but yet 100% loan banking is not.
Loan banking would be where you place your savings in an interest paying loan account from which the bank would make loans to third parties with. These loan banking accounts would be used to make loans to customers which must be paid back during a certain time window and depositors would also not be able to withdraw their funds during that same window of time. Bunk runs would be impossible.
Fractional Reserve banking is still a bit mysterious to me on how it is inflationary while the above banking is not. I realize that a fractional reserve bank is subject to runs, but how is it inflationary? If a bank has a $1000 deposit and loans out $900 of it under the full extent allowed with a 10% reserve requirement. How is this inflationary? I know that the bank now has $1900 on its books but the original depositor is not using his $1000. It doesn't seem like any new credit has been created. So as long as the bank does not experience a run, how is this inflationary?
I am very interested in clearing this up for myself so that I can more properly explain this to others.
I will try to explain this (and hopefully get it right as well).
Loan Banking
You loan $1000 to Bank A. Bank A loans out that $1000 (I won't include interest and such). Bank A then after the specified date gives you back the $1000. No new money has been created.
Fractional Reserve Banking
You deposit $1000 to Bank A. Bank A opens a demand deposit (checking account) for you, allowing you spend your $1000 at any time. Bank A, however, issues 50% of the $1000(so its easier) to Person B by opening a demand account for them, meaning that Bank A gave them a $500 loan. You have the power to $1000 whenever you likes and Person B has a $500 loan. However there is only $1000 to back both of you up. The Bank just created $500 out of thin air.
Technically it is not inflationary as long as Person A doesn't spend his deposit money. Once starts spending the money the inflation will kick in.
Fractional reserve banking is when banks take money out of demand deposits and lend them out. Since you can take your money out of demand deposits at any time, money is essentially created. If the reserves at two separate banks are 10%, and I deposit $100 in Bank 1, which then lends out $90, they essentially just created $90 because in my account it shows $100 + $90 that they created. When the borrower takes this money and deposits it in the bank, the money is again multiplied from $90 to a total of $171 (90*1.9=171) and loans out $81. So from savings of $100, the banking system just created $171 worth of credit, driving down interest rates.
Full reserve banking, on the other hand, is only when banks take money from time deposits, which may not be accessed by the time deposit holder at any time. In other words, you can't take money out of the bank while it's loaned out. So if I put $100 in a time deposit, $100 is loaned out. The borrower may then put it in a demand deposit, where $0 would be loaned out, or they could put it in another time deposit where all the money would be loaned out. However, no additional money is being created here because the deposit holder cannot use the money in the deposit while it's being used by borrowers.
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If a fractional reserve bank has 1000$ in deposits but 1500$ in loans, people think the money supply is 1500$ when in fact it is only 1000$. When this illusion collapses, there is a bank run.
The idea that the depositor is not "using" his 1000$ is nonsense. If he did not want 1000$, he would sell it in exchange for an interest-earning asset, or some other good. If he keeps a 1000$ deposit it is because he is using it.
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krazy kaju:Since you can take your money out of demand deposits at any time, money is essentially created.
But wouldn't depositor withdraws come from the 10% reserve requirement that the bank holds of all deposits?
Lets say that there are 10 depositors at a bank who all have $100 on deposit for a total of $1000. And lets also say that one single customer takes a $900 dollar loan. This therefore leaves $100 left at the bank for its 10% reserve requirement to prospectively satisfy any bank withdrawls that the original 10 depositors may have. This obviously runs large risk of having a bank run, but so long as this does not happen where does the inflation part come into play?
I am getting these questions a lot from family and friends who think that I am full of it, so help me out! My dad is even a banker and he defends fractional reserve. I need to be able to defend myself and sound money! Thanks.
Right, but those original 10 depositors can take out their respective $100 anytime they want. This is where the new money enters the picture. The bank has $100 to satisfy potentially $1000 in withdrawals.
new money enters the picture as the 900$ loan you mention goes into another bank deposit account, and is the basis for further loans.
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polskash: Right, but those original 10 depositors can take out their respective $100 anytime they want. This is where the new money enters the picture. The bank has $100 to satisfy potentially $1000 in withdrawals.
In that scenario, wouldn't the Federal Reserve have to step in as lender of last resort? Is that where the new inflationary money would come from?
the money supply is inflated teh first moment the bank loans money to anyone, and uses money of another deposotir to do this, becasue that original depositor still has a valid legal claim to some money, and this is money that the loand recipient also claims. the money is doing doble duty. this is magnified throught the money multiplier
James Greene: In that scenario, wouldn't the Federal Reserve have to step in as lender of last resort? Is that where the new inflationary money would come from?
The Federal Reserve would have to make a choice. Either it honors the real money supply at 1000$ by letting the bank fail, or the inflated money supply at 9000$ by protecting the bank from a run. In the time of a gold standard it was forced to let the bank fail, thus protecting the value of money.
Essentially a deposit contract works as follows an individual makes a contract with his bank stipulating that the bank will hold a certain amount of his money (whilst perhaps, providing other goods such as cashier services) and that the depositor will the pay the bank for this service. The service entails that the depositor will have access to his money at all time, the bank must therefore be obliged to always keep full availability of the money to the depositor. Given this, the depositor is not exchanging present goods for future goods, he retains full availability of the goods in question and understands this. He will act in accordance with this.
In a loan contract, there are two steps. The first is that an individual lends a certain sum of money to the bank, thereby giving up consumption for a certain period of time. This entails an exchange, on behalf of the creditor, of present goods (to the bank) for a greater sum of future goods (from the bank). He is fully aware that he no longer has access to these funds. Upon receiving these funds the bank will look for somebody wishing to take out a loan to whom they can lend the funds (at an interest rate higher than they received the money), in doing so the individual in question gains present goods and will, in the future, have to return a greater amount of goods.
In a 100% reserve system, loaning is almost entirely carried out as described in the second paragraph, the bank acts as a true financial intermediary. The creditor gives up present goods which are then indirectly transfered to the debtor. However, in a FRB system, the depositors are turned into forced creditors. Money is created from the deposits the bank is holding and transfered to the the debtor. Both the debtor and the creditor will spend the increased sum of money as if they both had complete access to it, thereby increasing the money supply.
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I fail to see how fractional reserves can be inflationary. Without an increase in base money reserve ratios would have to constantly fall.
scineram: I fail to see how fractional reserves can be inflationary. Without an increase in base money reserve ratios would have to constantly fall.
I too still fail to see how fractional reserves can be inflationary. I see it as being very risky because of the potential for bank runs, but I fail to see how or where new money is actually created.
I have $100 in a demand deposit and $90 is loaned out. I buy something online for $50, the money is transferred from my bank account to the online vendors. In this situation, we have the borrwer using my $90 and myself using $50 for a total of $140, even though there is only $100 in bank deposits.
If fractional reserves weren't inflationary, there wouldn't be a difference between M0, M1, and M2.
James Greene:In that scenario, wouldn't the Federal Reserve have to step in as lender of last resort? Is that where the new inflationary money would come from?
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