If banks would not be allowed to lend out more than what they have in terms of deposits, or if they would only be allowed to lend out twice that amount, what would be the most significant difference with the current fractional reserve system (in which the cash-reserve ratio can be as high as 1:9)?

I’m reading that the current system increases the availability of credit, which in turn helps the economy to grow. But if banks would only be allowed to lend out half of what they are currently lending out, wouldn’t the supply of money simply go down, and thus the value of money up, effectively leaving banks with the same lending power?

Current system:

  • Total amount of money in circulation: central bank money x money multiplier. Most money is created by commercial banks.

Alternative system:

  • Total amount of money in circulation: central bank money. All money is created by central banks.

I’m not asking what would happen if this would change over night (e.g. sudden decrease of money, monster deflation etc.). I’m asking what is the benefit (and to whom) of doing it the way it is currently done.

  • xNIBx
    2•1 year ago

    But if banks would only be allowed to lend out half of what they are currently lending out, wouldn’t the supply of money simply go down, and thus the value of money up, effectively leaving banks with the same lending power?

    Well that leads to deflation and it’s bad.

    While money is often a representation of wealth, ultimately, money is just a medium of exchange. Think of it as the blood of the economy. Pooling the blood in 1 location isnt beneficial for anything, you want money flowing all over as much as possible and this is facilitated through fractional reserve. The only time you dont want money flowing everywhere, is if you have high inflation, in which case you take measures that restrict the availability/flowing of money.

    Even if you could slowly and carefully raise the ratio, why do you want a higher reserve ratio? What does that achieve? Ideally, you want 0 money being unused, though for practical reasons(people being able to withdraw money when they want to), you want to keep some money in the vault.

    To think of it in a more conventional terms, imagine if a company had really deep stock of shoes. You dont want to store 1 million pairs of shoes in case 1 million people suddenly decide to buy shoes in 1 day. You only want to keep in storage as many shoes you sell on average, + a percentage. Sometimes this will lead to supply chain issues, like with covid, but 99.9% of the time, it works great.

    In the words of the ancient greek philosopher Chrome “unused memory is wasted memory”. The same principle applies to money.