Fractional Reserve Banking
FRACTIONAL RESERVE BANKING
Fractional reserve banking is a system under which bankers keep as reserves only a fraction of the funds they hold on deposit. This system has three features:
• Bank Profitability By getting deposits at zero interest and lending some of them out at positive interest rates, goldsmiths made profits. The history of banking as a profitmaking industry was begun and has continued to this date. Banks, like other enterprises, are in business to earn profits.
• Bank Discretion over the Money Supply When goldsmiths decided to keep only fractions of their total deposits on reserve and lend out the balance, they acquired the ability to create money. As long as they kept 100 percent reserves, each gold certificate represented exactly 1 ounce of gold. So whether people decided to carry their gold or leave it with their goldsmiths did not affect the money supply, which was set by the volume of gold. With the advent of fractional reserve banking, however, new paper certificates appeared whenever goldsmiths lent out some of the gold they held on deposit. The loans, in effect, created new money. In this way, the total amount of money came to depend on the amount of gold that each goldsmith felt compelled to keep in his vault. For any given volume of gold on deposit, the lower the reserves the goldsmiths kept, the more loans they could make, and therefore the more money would circulate. Although we no longer use gold to back our money, this principle remains true today. Bankers’ decisions on how much to hold in reserves influence the supply of money. A substantial part of the rationale for modern monetary policy is that profit seeking bankers might not create the amount of money that is best for society.
• Exposure to Runs A goldsmith who kept 100 percent reserves never had to worry about a run on his vault. Even if all his depositors showed up at the door at once, he could always convert their paper receipts back into gold. But as soon as the
Fractional reserve banking is a system under which bankers keep as reserves only a fraction of the funds they hold on deposit. This system has three features:
• Bank Profitability By getting deposits at zero interest and lending some of them out at positive interest rates, goldsmiths made profits. The history of banking as a profitmaking industry was begun and has continued to this date. Banks, like other enterprises, are in business to earn profits.
• Bank Discretion over the Money Supply When goldsmiths decided to keep only fractions of their total deposits on reserve and lend out the balance, they acquired the ability to create money. As long as they kept 100 percent reserves, each gold certificate represented exactly 1 ounce of gold. So whether people decided to carry their gold or leave it with their goldsmiths did not affect the money supply, which was set by the volume of gold. With the advent of fractional reserve banking, however, new paper certificates appeared whenever goldsmiths lent out some of the gold they held on deposit. The loans, in effect, created new money. In this way, the total amount of money came to depend on the amount of gold that each goldsmith felt compelled to keep in his vault. For any given volume of gold on deposit, the lower the reserves the goldsmiths kept, the more loans they could make, and therefore the more money would circulate. Although we no longer use gold to back our money, this principle remains true today. Bankers’ decisions on how much to hold in reserves influence the supply of money. A substantial part of the rationale for modern monetary policy is that profit seeking bankers might not create the amount of money that is best for society.
• Exposure to Runs A goldsmith who kept 100 percent reserves never had to worry about a run on his vault. Even if all his depositors showed up at the door at once, he could always convert their paper receipts back into gold. But as soon as the