In economics, there is a multiplier effect with bank lending. For example, if the banks lend 90 percent of the money in their reserves, then the amount of money increases by 90 percent. By controlling the amount that banks keep in reserves, the Federal Reserve can control inflation/deflation.
What is wrong with this?
The fact that this is exactly how it causes inflation, perhaps? [^o)]
-Jon
It is too neat. The new money does not appear everywhere at once, creating a universal and simultaneous price-inflation that the Fed could observe and take as feedback. Likewise banks will not call money in from everyone at once when they are required to maintain more of a reserve.
The problem with this is that it causes wild and out of control inflation that forces real interest rates to rise. This dampens demand (less credit = less demand) and throws us into a depression.
Also, I’d like to point out that the multiplier effect isn’t only about fractional reserve banking. Even in a system with full reserve banking you have a multiplier effect that could be considered “better.” Essentially, for every dollar created, someone gets it and spends some of it, that spent money then gets spent by someone else, ad infinitum. The amount spent is called the multiplier effect. The multiplier effect is also used for increased government spending, decreased taxes, and increased exports.
The problem with the multiplier effect is that it completely ignores inflation, and the wreck that inflation causes to the economy.
All the reserve ratio requirement means is that it affect the yield offered deposits and rate charged on loans.
Suppose the Fed Funds Rate is 2% and the price of a loan is 5%. A typical deposit has a reserve requirement of 10x. Assuming the bank has expenses associated with servicing deposits. Then, deposits will yield 2%. It’s irrelevant if the bank borrows from the Federal Reserve at the Fed Funds Rate or borrows from depositors. Suppose the bank borrows $1M at 2%. The bank then lends $0.9M at 5%, earning a profit of 2.5% per $1M borrowed and $0.9M lent.
Time deposits have no reserve requriement. Therefore, a time deposit will yield 2.5%. Suppose the bank borrows $1M at 2.5% via a time deposit. Then, the bank lends the full $1.0M at 5%, earning a profit of 2.5% per $1M borrowed and $1M lent. (I ignore the effect of interest rates changing over time.)
All the Federal Reserve accomplishes by changing reserve requirmements is that it changes the lend/borrow spread.