[jmherbener]

The current monetary system has fiat money produced by a central bank and fiduciary media (money substitutes with a fractional reserve of money). The point of the system from the view of the state is to permit unlimited monetary inflation and credit expansion controlled by the state. The state desires the system to have fractional reserve banking because that is the source of credit expansion and credit expansion is the method the state uses to fund its own debt. Credit expansion is also lucrative for banks. In fact, it is so lucrative that banks have a tendency to extend it too far setting in motion bank runs. So the state must regulate the fraction to keep the banking system intact.

If the central bank wants monetary inflation and credit expansion it could provide more reserves to the banks by issuing fiat money and buying assets from banks or it could allow banks to lower the fraction of their reserves or some combination. Normally, the Fed has left the reserve fraction the same and regulated monetary inflation and credit expansion by buying assets from banks. Before the crisis, banks held a 6-7 percent reserve against their fiduciary media, i.,e., their checkable deposits.

I cover these points in my lecture on Monetary Policy. Also, take a look at Rothbard’s, The Mystery of Banking.

http://library.mises.org/books/Murray%20N%20Rothbard/Mystery%20of%20Banking.pdf