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.
Velocity of money is one of the most vital monetary policy concepts. The more time/faster money flows through the economy the more things are bought with each dollar. Fraction reserves means if your bank is allowed to lend 90% of what is deposited. That gets spent and deposited somewhere else where 90% of it is spent and so on down the line.
This keeps cash flowing and available throughout the economy. When people feel like they can no longer access funds for things, they stop spending money. People spending money is what keeps the economy working. Keeps everyone employed, making products and providing services.
It’s pivotal to our entire current economic system and changing it would have severe ramifications. I don’t entirely agree with how credit, fractional reserves and leverage is used today. But there’s no denying changing it would be painful.