[miljacic]

Over the years I keep stumbling on this question again and again. Somehow I’m missing something. I’ll have to apologize if this common question was already answered on the forum or lectures.

So, Is Fractional-Reserve Banking increasing the total amount of money in circulation or not?

Let me use a common example. A cleaning lady working at the Central bank gets her $1000 salary in cash, which the central bank has just then printed as new money. Total amount of money in circulation has obviously increased by $1000.

The lady opens a new account in a commercial bank and deposits the money there. Under 10% reserve requirement, the bank then loans and re-loans this money until a total of all new deposits reaches a mathematical limit of (nearly) $10,000 at various accounts. At the same time bank holds only $1000 as the new reserve.

Question: can these people now, at any single instance of time, have these $10,000 withdrawn from the bank, or any amount over $1000? If they can, then the commercial bank can increase the amount of money in circulation. But if they could collectively have withdrawn only up to $1000 at any single instance of time, then commercial bank cannot grow money supply in circulation.

From another angle. Let’s say one of these people goes to a bakery and buys a $2.50 croissant, paying with his debit card. The baker swipes the card, a message appears saying “approved”, and then baker gives the croissant out.

Has the commercial bank instantly lost $2.50 of its reserves? Or has it instantly lost $0.25 of reserves (10% of it). Or has it instantly lost 0 reserves… until some later moment (in an hour, or later that day, or tomorrow, or a week after) when information about this croissant purchase will be processed by the bank and its reserves reduced appropriately?

Thanks!

[jmherbener]

When one person pays another person by writing a check or swiping a debit card, the claim to money itself that the first person had is now transfers to the second person. The customer who buys the croissant sees his checking account balance fall by $2.50 while the merchant who sells the croissant sees his checking account balance rise by $2.50. The overall amount of claims to money has stayed the same. If the customer and the merchant use the same bank, then the reserve position of the bank stays the same. If they use different banks, then the bank with expanding checking accounts will need to acquire reserves from the bank with contracting checking accounts. The expanding bank can sell securities to the contracting bank to obtain its reserves. Alternatively, the expanding bank could borrow reserves from the contracting bank. This is done everyday in the so-called Federal Funds Market. As long as expanding banks can acquire reserves from contracting banks, the money stock need not shrink when one bank experiences contracting checking account balances.

[miljacic]

Thank you Mr Herbener.

So, to make sure I got it, all that a commercial bank needs is some sort of “buffer monetary reserve”, that will make sure that daily fluctuations (money from the bank’s deposits moving to other banks) can be temporarily covered.

Such fluctuations are many for banks having hundreds of thousands of customers, and they will tend to cancel out. Maybe at the end of each day only small offsets remain…. let’s say about a billion of $ leaves a bank, about a billion comes in, and maybe only a few millions are a daily offset, for which banks have well prepared reserve buffer. Am I correct?

If so, then my question is answered, commercial banks are able to increase money supply in such roundabout ways. In my example from the post above, the initial $1000 deposit can originate $10,000 in various deposits, which can safely change hands between commercials banks, following the exchange of real (physical) goods and services.. just what these dollars would do if they were “printed out of thin air”.

[jmherbener]

Yes, you are correct. Put another way, all banks together constitute a banking system in which the reserves held by all banks lead to a multiple expansion of fiduciary media issued by all banks. The distribution of reserves among the banks does not affect the ability of the system to maintain the overall issue of fiduciary media.

[miljacic]

Got it. I now have to thank a friend of mine who is a skeptic and who managed to confused me the other day. But all this now pushed me to a new level of understanding.

It’s kinda interesting to look at this from a sort of temporal aspect. Fiduciary media “appears” for a millisecond and then immediately “disappears”, confusing the observer to think that money supply has not been expanded.

What I mean is the following…

In the naive (very old-fashioned) way of thinking, if I deposit $10 in the bank, and the bank lends 90% of it to someone else, then (if this was really-really money) I should not be able to use it anymore. The money is simply physically gone from my account.

But that’s not how things work… I deposit $10, nine dollars go to someone else, but I can still use all of it at any moment! I can still buy that $2.50 croissant using the money that is not there!

So what happens, from my point of view as a consumer and a customer, when I go to bakery and ask for $2.50 croissant, offering my debit card while supposedly having only $1 “really present” in my “$10 account”? The fiduciary money “springs into existence” for a millisecond, just enough for the machine to write “approved” and other related electronics to flicker things through, and then it disappears from the realm of physical phenomena.

This “quantum of fiduciary media” has to spring into existence (to start a physical chain of events) at least for a very short while (millisecond, nanosecond, depending on the electronics involved). But in the old-fashioned, naive viewpoint, since the money is not there it could not spring into existence even for that nanosecond, since it is not physically present, and so the exchange of goods and serviced can not happen.

All this is very confusing to a common, uninformed mind. This “brief springing into existence” of fiduciary media makes the temporary (yet substantial, effect-producing) increase in total money supply.

There is an interesting analogy in Physics. We all know that the total energy of a closed physical system is conserved, and that nothing can ever break that law, right? Energy can change its form but not the total amount. Well… until quantum theory arrived. In this theory, brief quantum fluctuations can “spring into existence” without costing any energy, cause observable effects, then disappear, remaining unobservable. This is pretty much how I now see these.. how to call them.. “fiduciary-money fluctuations”.

So, the fact that banks must hold only a fraction of a deposit as reserve and can lend the rest is not the reason money supply is expanded. So blaming just the fractional-reserve-requirement is not correct. The real reason is that commercial banks are allowed to use these deposit-receipts (IOU’s) among themselves as if they were money. Something that is totally-not-money is used as money, and they have a sort of monopoly on this (granted by the government).

This was very helpful to me, thanks again.

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