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 $0 would be loaned out, or they could put it in another time deposit where all the money would be loaned out. However, no additional money is being created here because the deposit holder cannot use the money in the deposit while it’s being used by borrowers.
If a fractional reserve bank has 1000$ 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.
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 $1000 in withdrawals.
the money supply is inflated teh first moment the bank loans money to anyone, and uses money of another deposotir to do this, becasue that original depositor still has a valid legal claim to some money, and this is money that the loand recipient also claims. the money is doing doble duty. this is magnified throught the money multiplier
The Federal Reserve would have to make a choice. Either it honors the real money supply at 1000$ 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.
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.
Let’s say you make a deposit of 10 ounces of gold. The bank lends out 5 ounces to Smith. So Smith has 5 ounces to spend.
Now, the bank tells you your 10 ounces are available on demand. So, you can spend 10 ounces. And Smith can spend 5 ounces. The money supply has magically increased by 50% !!
Also Smith may get physical gold…or paper. And you may withdraw metal…or paper. Being able to print a number in a piece of paper is oh so convenient.
In the current system the same thing is going on, except that ‘cash’ now means greenbacks instead of gold.
So, you deposit $1000 fiat dollars. The bank lends out $500. Total money supply $1500. True, no new physical greenbacks have been printed. There’s no need to.
Also, the money supply has increased but the supply of real goods and services produced by real people has not increased so the ratio between money/services/goods (aka prices) will change to reflect the new situation. Things will get more expensive in nominal terms.
I think that I agree with you, but let me give the the argument that my banker father gives:
You deposit $1000. The bank lends out $500. The total money supply is still $1000 with the bank now having only $500 on reserve to satisfy potential customer demands and the lent out $500 that the debtor now has. No new money created. The only risk is that the original depositor will try to redeem anything more than $500 and the bank will be proved insolvent. Now, where does inflation come into play? It does now appear to anywhere.
No it is not. Notice that now there are two people who can spend money. You can spend your $1000 and the other guy can spend his $500. Total $1500.
But this is not directly related to what other depositors may or may not demand. The thing is, by lending money that is supposed to be available on demand the banker has created an imbalance of sorts. He can cover it up for a while using more money other people deposit…a typical ponzi scheme, but sooner or later the system crashes.
Inflation is staring you in the face =] As I said, before putting your money in the bank there was only one actor (you) who could spend $1000. Putting your money in the bank theoretically means you still have $1000 and can buy $1000 of stuff and Jones (borrower) can buy $500 of stuff, but no new stuff has been produced. Inflation.
I think that you were correct if there existed only one single bank in the economy! But we have a banking “system”.
The trick is that the $900 loans can be deposited as cash in other banks. These banks keep 10% reserve and lend $810 to other banks. Those banks keep 10% reserve and lend $729 to still other banks and so on and so on. As a geometric sum it adds up that with x% reserve, FRB can create 1/x% dollars out of every initially deposited dollar, like 1/10% = 1/0.1 = 10 FRB money multiplier.
Such multiplier maximas are quickly reached because most money stays in the banking system all the time nowadays. If someone has deposited $1,000,000 in a bank, and you borrow $900,000 from that bank to buy a house, you don’t withdraw it in cash. You just transfer it electronically to the house sellers account in another bank. Those $900,000 is thereby deposited in the house sellers bank, which uses it as reserve for lending $810,000 to a Ferrari buyer. The Ferrari seller deposits his recieved payment of $810,000 in yet another bank, which uses it as reserve for lending $729,000 to whatever and so on.
The problem is that loans are considered to be money reserves. When a bank is required (by the government) to hold reserves, it suffice if those reserves consist of money loaned from other banks. If $1,000 is all cash dollar which exist, then there exist $10,000 FRB dollars deposited. When people want their deposited FRB dollars back in cash, their overall loss will be 90%. (But with first-come-first-served or government “rescue packages” the losses will of course not hit everyone proprotionately).
For sure, those loaned money used as reserves in every step, have securities in the shape of the customers owning the money. It could be houses or cars or just obligations to pay in the future once based on the individuals income and credit history. So if everyone claimed all their deposited money back from the FRB-system, total losses will be 100% minus 10% ultimate cash reserve, minus the second hand value of the securities of the borrowers. Since all this credit-money-multiplying boosted the prices and imaginary values of the assets used as securities to begin with, the whole bubble mechanism does get quite interesting…
Inflation is the debasement of the value of money which sometimes is reflected in rising prices for a particular good. Rising prices for a particular good are not neccessarily due to inflation; and inflation will not neccessarily cause a rise in the price of a particular good.
Fractional reserve banking tends to inflate the money supply as explained in the prior posts.
All other things being held equal, if there are $1,000 dollars in the entire world which will buy say the only pound of unobtanium in the world and then the fractional reserve bank artificialy expands the world’s money supply to $1,500, then that pound of unobtanium would now cost $1,500 because the newly created additional units of money are not backed by true capital.