We teach Austrian Economics in a fun way!

Fractional Reserve Banking vs. 100% Reserve Banking

What is the difference between fractional reserve banking and full reserve banking? How do they work? Do they have advantages and disadvantages? Is one better than the other? We hired a detective to check it out.

We gave the detective $1000 to trace what happens to the money after depositing it in the bank. He started with the fractional reserve bank and deposited the $1000 there to open a free account. The bank told him that all of his money is still available to him on demand. He can withdraw his deposit at any time.

Our detective suspected, however, that he should take a closer look, or else he wouldn’t get paid for his detective work. With a little research, he discovered that the bank only holds a part or a fraction of deposits in reserve, and that this fraction for this bank was 10%.

The detective watched the teller, and noticed that instead of safely depositing the entire $1000 in the vault, she only put $100 in the vault and then gave the other $900 to another bank customer who was asking for a loan to purchase a new TV.

“Something’s fishy,” thought the detective. “Let’s see what happens next.”

The detective followed the borrower to the electronics store where he bought the TV for $900. The store owner took the $900 he just earned from the sale of the TV and deposited it in the same bank! And the bank told him the same thing they told the detective – “All of your money is still available to you on demand. You can withdraw your deposit at any time.”

And again, the teller took 10% of that $900 and placed it in the vault ($90), but gave the other $810 to another borrower to buy a nice new leather jacket. Moments later, the seller of the leather jacket walked into the bank with $810. The teller put $81 in the vault, and gave $729 to another borrower, this time an elegant lady who wanted the money for a new purse.

The process repeated itself over and over again until the original deposit of $1000 had created 9000 additional dollars.

The detective, after running around the city all day, came back to us with four conclusions.

Conclusion 1

The account was free because the bank makes money off of lending deposits to other people. However, if everybody came to withdraw their deposits at the same time, the bank would be in big trouble.

Conclusion 2

The bank earns interest on the newly created $9000, but the real deposit was $1000. A little strange, isn’t it?

Conclusion 3

As we know, money itself is not real wealth, except that it allows us to purchase the goods and services we actually want. By creating a larger money supply and not a larger supply of goods and services, prices of goods and services increase and the purchasing power of all the money decreases, including the “old” money that originally existed before the fractional reserve lending process.

Conclusion 4

The lower the fraction of reserves held, the more the bank can lend to others. If the fraction was 5% in this scenario, $19000 could have been created out of thin air.

The next day, we gave the detective another $1000 to investigate a 100% reserve bank.

He walked into the bank and deposited $1000 to open a new account. The teller informed him that the bank charges a fee for the safekeeping of funds, so the account is not free. The detective winced a little, because nobody wants to pay for an account they could have for free at another bank.

Then the teller said, “We cannot move your money without your consent, but if you have no need to use all or part of your money for some time, you can loan it to us for that time period and earn some interest. You’ll get all of your money back plus interest.”

The detective decided to go for it. He deposited $100, or 10% of the money, and allowed the bank to borrow the other $900 for a year. The teller then put $100 in the vault and gave the $900 to a customer who wanted to borrow it to buy a new TV. Then the electronics store owner came back to the bank with $900, and decided to deposit all of it so he could have it on demand. He did not lend any of it to the bank.

The detective noticed that this looks a little bit like the fractional reserve banking, but there is one major difference: there is no money creation. The detective gave up the $900 for a year to the bank, understanding that he would not have access to it for that time period.

Over the next year, the money will be paid back by the guy who bought the TV and then the bank will give the detective the $900 back plus some interest.

In summary, the seller of the TV has not received new money in this case. The detective parted with it for a time, but will get it back later when the TV buyer pays down his loan to the bank. At the end of the day, the detective brought us four more conclusions.

Conclusion 1

The demand deposit was not free. It had a fee because the bank was providing a service for the depositor: the safekeeping of the money. Any interest earned was only on the money lent to the bank and to the TV buyer.

Conclusion 2

There is no new money created, therefore the money does not lose its purchasing power as a result of bank lending in a full reserve system.

Conclusion 3

As long as the banks maintain full reserves, it will always be able to redeem their customers’ demands for withdrawing their deposits. There’s no risk of insolvency in this regard. All of the customers can come in and claim their deposits with no problem.

Conclusion 4

All of the lending was contractual, and there is no “fishy business” going on with the bank. It was clear to the detective that $100 was being deposited and $900 would not be available to him for a year because he was lending it to the bank.

Good work, detective!

2018-07-23T17:15:37+00:00