How does fractional reserve banking increase prices?

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    How does fractional reserve banking increase prices? (say, in a fiat monetary system)

    I was having a discussion with someone that claimed that fractional reserve banking is not “inflationary” in that it increases prices because the base money stays the same and prices only increase “when more dollars are chasing the same amount of goods, but since the actual amount of physical dollars isn’t increasing then there can’t be inflation:

    “Monetary inflation raises prices when more dollars are out there competing against each other trying to be exchanged for goods. Money sitting in a bank account or under a mattress is not out there competing against other dollars for goods. If our First Depositor had gone out and spent his $1000, he could have gotten $1000 worth of goods. If he deposits $1000 in the bank (and isn’t spending it) and the bank has its 10% reserve requirement and loans out $900, then the most which can be spent is now $900, not $1000 so there are actually FEWER dollars chasing goods than there potentially could have been. The bank is keeping the other $100 out of the market basically. Person A (First Depositor in the example) traded buying something today with Person B (First Borrower). Person A will have money to spend in the future when he takes his money out of the bank but person B will have $900 less than he would have since he had to use that to pay off his loan (plus interest). Person B traded spending money tomorrow for spending money today. They shifted their time preferences with each other”

    Intuitively I believe that since the “IOU’s”, which are the checking account balances are treated exactly the same as base money and since people treat their checking account balances as money then in the aggregate people believe there is more money than actually currently exists. Am I on the right track?


    The purchasing power of money (i.e., the inverse of prices) is determined by the stock of money and the demand for money. The stock of money consists of money proper and money substitutes. In a fractional reserve banking system, banks issue fiduciary media, i.e., money substitutes for which they hold only a fraction of money in reserve for redemption. It follows that the banking system can expand the money stock by issuing fiduciary media and thereby, generate price inflation.

    Your friend has not thought through the logic of his example. If the 1st bank keeps $100 dollars and lends out the other $900 of the original $1,000 in cash deposited, then the borrower spends the $900 and the merchant receiving the money deposits it in his bank. The 2nd bank then keeps $90 and lends $810 (now the banking system has created $1,900 of money substitutes already on the $1,000 in cash). And so on the process continues until the banking system creates $10,000 in fiduciary media on top of the $1,000 cash reserve. So even if the original depositor doesn’t spend his $1,000 deposit, the fractional-reserve banking system is inflationary. Of course, instead of going through this indirect process, it’s more likely that the 1st bank simple issues a loan of $10,000 to a customer and puts the funds in his account in which case it would be meeting the reserve requirement ratio of 0.10 and yet it has created $9,000 additional dollars of money substitutes.


    Doesn’t the money supply decrease as soon as a loan is repaid? And if yes, does the money supply not stay more or less the same over a long period of time (if we assume that there’s no central bank)?


    The money stock decreases only if the bank decides not to issue fiduciary media by extending another loan to another borrower. As long as the bank desires to hold no excess reserves, then the money stock will not shrink.

    Even if there is no central bank increasing the reserve of money upon which the banking system issues fiduciary media, the banking system can still steadily increase the money stock by reducing the reserve ratio. In a fractional-reserve system, the reserve ratio is set by the practical limits of redemption of bank money substitutes. Under some configurations of fractional-reserve banking, the banking system can progressively lower the reserve ratio even without a central bank.

    Take a look at the relevant sections (e.g., chs. 16-18) of MIses’s Theory of Money and Credit:

    For a configuration of free banking on 100 percent reserves, take a look at Joe Salerno’s article in Guido Huelsmann’s new book, Theory of Money and Fiduciary Media:

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