Around the world the money supply is managed under a fractional reserve/ capital requirements system. This is a great system for supporting the growth of a country’s economy. There are some pitfalls though and their are economists that believe some if not all the current worldwide economic challenges can be attributed to the fractional reserve system.
What is it?
The fractional reserve concept is based on the theory that only a small percentage of money will be withdrawn from a bank at any time. The bank keeps a minimum amount on deposits (i.e., that cannot be lent out) and lends the rest. Over time the borrowers pay it back and as long as there is not a run on the bank that exceeds the amount of cash on hand at a given point all is fine.
Given the people the money was lent to spend it, ultimately it gets returned to the bank as a deposit. As a deposit the amount can be lent again (to the reserve limit). You can see the cycle continues and the money supply grows.
NOTE: Some country’s regulate the amount of money bank’s actually hold based on capital requirements versus a mandated % reserve (Canada is one of these).
How about an example?
Consider a country with only one bank. The central bank issues currency of $100, and to make the example simple all of this currency goes to Bob. Bob deposits the $100 in the bank. The bank is required to hold at least 3% but can lend $97. The bank lends it to Jerry who spend it on a house Bob owns (ie, he pay’s it to Bob) Bob deposits the $97 in the bank and they in turn lend all but 3%. The bank is now holding $5.91 in cash, has liabilities of $197 (Bobs deposits) and assets of $191.09 (the loans they made) plus the reserve cash. The country’s money supply is now $394. The money supply has increased more than 288%. And the cycle continues as the money is paid back, then lent out the to the reserve limit, then deposited, so more money to lend. And so on. The money supply grows and can be used to build stuff and sell it, and pay salaries and buy stuff.
So the system is all good, the economy grows, there is good liquidity, money is available when needed. What can go wrong?
The upward cycle is dependent on goods and services being created and purchased. These also need to maintain their value at least for the cycle to continued unimpeded. Say you borrow $97 and buy a house. If the value of the house drops to $50 you might walk away from the loan. This puts the bank at risk of being able to return the depositors money. Simply put this scenario can cause the upward spiral to go the other way (down). Ooops.
What’s my point
The fractional reserve/ capital requirement economic system is extremely complex and I have grossly simplified it. .
There are many other factors and processes at play in our modern currency based economies but it all is underpinned by the money supply.
My intent is really to prick an interest which would lead you to research and knowledge gathering. There are alternatives to our current currency based economies (e.g., barter systems/ money supplies based on a fixed standard). And the world has tried some of these, for example the gold standard.
My own real question about the whole modern economic system questions the up and down cycle of the money supply that is intrinsic in the fractional reserve system – are we all really okay with that?
Good stuff banker man! As said by the intrepid blogger, the simplistic example makes the system sound quite scary because it is clear if jerry defaults the bank can’t pay bob if bob tries to withdraw and then the money supply goes “poof”. And though risks are real and there have been instances in real life of the system breaking the size and global nature of the economy are two major factors in keeping the cycle running, for many countries.