Fractional Reserve: Myths and Reality

Fractional Reserve banking: Myths and reality

"Fractional Reserve" banking has been targetted as one of the great evils by man
y conspiracy sites. One reason is that the concept and effect are often misunderstood or misrepresented.

So what exactly is "Fractional Reserve" banking?

Simply put: It means that a bank can loan out and/or invest some of it's deposits.

That's it.

Investing of deposits is necessary if depositers expect to get any interest on their deposits.

Contrast that to:

- 100% Reserve banking - where none of the deposits are loaned out. The consequence is that the deposit does not earn interest and the depositer has to pay the bank to be custodian over the deposit. This was very typical of checking accounts prior to 1980; the bank maintained 100% of the demand deposits and depositors paid a montly fee.

- 0% reserve - where the bank can lend out all the deposit. This typical of a CD or long-term time deposit. Because all of it can be loaned out for an agreed upon time frame, it can get the depositer more interest.

Anyone who does not like the idea of fractional reserve banking can opt out by putting their cash in a safety deposit box and withdrawl as necessary.

Relationship of fractional Reserve and 'Money Creation'

Econ 101 textbooks will tell you that a private bank loan creates money out of thin air and thereby increases the money supply. This is technically true only in terms of how the money supply is measured. In reality, private bank loans do not increase the amount of currency.

To understand, let's review how the Money Supply (M) is measured.

The narrowest measure of M is M0, or the 'monetary base'. Essentially this money created and controlled by the Federal Reserve. You can look it up any time at . Private bank loans do not affect this figure whatsoever.

Where it gets tricky is in the expanded version of M:

M = money in circulation (currency not in bank vaults) PLUS bank deposits.

So let's see how this works.

- Start with $1000 cash.
M = ($1000 (M0) PLUS $0 in deposits) = $1000

- Joe deposits $1000 into a bank.
M = ($0 (M0) PLUS $1000 in deposits) = $1000

- Jill borrows $500 from the bank and puts it in her purse.
M = ($500 (M0) PLUS $1000 in deposits) = $1500

- Jill buys a car with the $500. The dealer deposits the $500 into the bank.
M = ($0 (M0) PLUS $1500 in deposits) = $1500

- James borrows $250 from the bank and puts it in his wallet
M = ($250 (M0) PLUS $1500 in deposits) = $1750

So let's review…

A) Note that the amount of Cash never changes. There was always $1000 in the system. Sometimes it was in a bank vault , sometimes in peoples pockets or purse.

B) Each new loan pulled idle money from the bank and

M0 = M MINUS (All Loans)

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