I apologize if similar questions have been asked before. It was difficult to skim through all the existing FRB threads.
As far as I understand, today’s savings accounts are only possible in an FRB environment. With full reserves, you either have money storage (which does not create interest, but rather costs a premium) or direct lending (which means no constant access to your money).
But savings accounts are popular - in demand. Additionally, the demand for withdrawing cash is not very high, let’s say 10% of all savings at any time. A bank recognizes the potential and opens an FRB business, taking 100.000 currency in savings and loaning out 1.000.000 in paper promises.
a) Doesn’t this create a boom-and-bust cycle? Since money is just an indicator of society’s resources, this necessarily leads to misallocations, doesn’t it?
b) If customers are fine with a 10% reserve, how can this system be stopped? As long as noone withdraws, it keeps going, doesn’t it?
(a) Yes, fractional reserve banking creates boom/bust cycles. With 10:1 reserves, banks are amplifying the supply of demand money by 10x.
During a bust, people withdraw their cash and the money supply shrinks.
(b) The system ends when there’s a run on the bank. Everyone withdraws their cash simultaneously, but there’s only enough physical money to pay off 10% of demand deposits.
Usually, the State intervenes and declares a “banking holiday” or otherwise bails out the banks.
There’s a lot of good bits on the evils of fractional reserve banking on my blog.
No, it doesn’t. I’m going to assume that you’re understanding of business cycles comes from an Austrian perspective. Now, imagine in a full reserve system society suddenly decides (or, a large number of people in society decide) that they wish to hold less cash. If you assume that prices adjust upwards immediately, all is fine. However, let’s assume that prices are sticky upwards. If people reduce their cash holdings (read: savings) and spend more, a shift of resources from the future, to the present would be warranted. However, in the Austrian analysis the most important part of this is the relative price adjustments, which just wouldn’t occur. Ultimately what would occur is the market interest rate would stay where it is when it should be shifting upwards.
“society suddenly decides” – that should be enough to show that you don’t know what you are talking about.
“(or, a large number of people in society decide)” – that would also serve to illustrate your lack of a consistent method - alternatively you might want to explain why ‘a large number of people’ would all do X - you could also explain how large large is.
cash is always held, ‘the people’ will not succeed in holding less cash, as when one gives more cash in trade to another, that other has had more cash come in. all they can do is bid prices up in an attempt to en-mass reduce their cash holdings
change in the interest rates dont need to occur in the scenario. the premise of the situation did not require them to. it only required that there be a change in the purchasing power of the monetary unit, thats all that ‘everybodies demand to hold cash falls’ means. if the premise was a different premise like, people choose to invest more and consumer less or vice a versa then that story would play out in a change the interest rate fashion.
I agree that without FRB, savings accounts for demand deposits would pay zero interest or even charge the depositor for keeping the money. But banks will fractionally reserve non-demand deposits like CDs or bonds. In a truely free situation, a person may make an agreement where they can withdraw up to say 10% per week or somethings thus giving the bank the ability to fraction the rest.
a. Yes. The fractional reserve process ends up making 1/(Reserve Fraction) of money in circulation. There are two effects from this process: 1. Consumers borrow this new money and spend it on things in quantities that they would not do without the money. Businesses allocate real resources to this activities. These are the mal-investments. 2. Banks lend money progressively easier on terms as money like any other good must obey the law of Diminishing Marginal Utility and banks get easier on loans as they compete for borrowers .
b. These two effects then produce these negative consequences: 1. Businesses can not make profits without more easy money that is already all loaned out. These businesses are not providing products that consumers prefer and face bankruptcy. 2. Borrowers get too much cheap money and over extend themselves thus defaulting on loans.
b. Continued: Keep in mind that all banks are INSOLVENT. That is at any time depositors can withdraw their money and the bank can not pay the depositors. But even if there isn’t a run on the bank, the bank may not be able to pay depositors as its number of unperforming loans can rob the bank of cash with regular depositor behavior. In the FRB process a bank does not just lend out 10x deposits. It takes deposits then loans 90% of the deposit. These borrowers must put the money into a FRB account which then lends 90% of 90%. So you can see that each loan is covered by a deposit. So if a large enough portion of loans go into default then the bank can not make up with principal plus interest from its paying customers.