Is fractional reserve banking inflationary?

There are some contentious online debates you can find about this.

Do you think expansion of the money supply via fractional reserve banking actually causes inflation?

I say no, but what do you think?

My logic for the "no" answer is that personal debt counterbalances money in bank accounts (for the most part). Just like you are likely to spend more money if the bank owes you currency (i.e. you have money in a bank account), you are also likely to spend less money if you owe the bank that currency.

If the answer is "no", it obviously has implications for monetary policy. In that case changing the reserve requirement would be less likely to control inflation.

 

What kind of inflation are you talking about? The m2 money supply would rise, so I would assume economic theory would apply.

But what would inflate the most is the levels of debt, making them worth less.

 

This is from another thread, arguing why the Fed expanding the money supply does not necessarily have to create inflation.

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The answer is, it depends.

Inflation is caused by the effective money supply expanding faster than the quantity of goods and services in the economy.

Fractional reserve banking is part of the equation. Basically, when a bank lends money, it creates addtional deposits that are generally considered to be "money." But the amount of deposits that can be created in this way is a function of the amount of "base money" (coin and currency and their electronic equivalent, reserves at the Fed), the reserve banks are required to maintain, and whether the banks are lending to capacity (and the velocity of money).

As I explained in the other thread, this logic makes no sense to me. People don't get loans to sit on the cash and pay interest. They take loans to utilize the cash, whether to make purchases or investments.

But the unchecked creation of money, whether base money created by the Fed or deposit multiplication by bank lending, can definitely cause inflation, and indeed hyper-inlfation. There are many such examples.

 

That is a better definition, but even that is not quite true.
In my example I gave, that would seem to hold true because the Fed is taking out assets at the same time it is adding in money, so the two would counterbalance each other, you would assume, and there would be no net inflation.

However, like I said before, there's somewhat of an assumption that the economy makes that the Fed is going to sell off those assets at a future point in time, so that's what gives value to the dollar and prevents inflation from being proportional to the money supply.

It's also true that the dollar derives some of its value from the government collecting dollars in taxes. So this makes things a little more complicated, because the dollar doesn't only derive its value from the Federal Reserve assets backing it.

The Federal Reserve expanding the money supply usually does cause inflation, but that's because when they are expanding the money supply they are usually trying to manipulate some aspect of the economy and are purchasing assets for a slightly higher price than the open market would be willing to pay for those assets.

 

No, because what the Fed creates, base money, is the type of money that is used for transactions on a daily bases.

Assets the Fed typically buys, long term US Govt bonds, are not the equivalent of money and don't cause inflation.

It's not value that makes something money. A house has value, for example. But its not money.

 

But when the Fed creates money, it is also creating future demand for that money.

They don't just simply throw out free money. They buy up people's assets, usually debt. Those people are going to need those dollars to pay back their debts.
This creates a counterbalancing effect against inflation.

 

How so? There's always some demand for money. It may be stronger at times when the economy is humming and people want money for projects and investments and to buy stuff.

But I don't see how the Fed creating money creates demand. It increases supply.

Wait, it seems like you are confusing something.

When the Fed buys an asset (say a Govt bond) to inject new money into the economy, they buy the bond from the holder. To the holder of the bond (who sells it) it is an asset, not an obligation or liability. They may need or want dollars for other things, but they don't need it because of bond the are holding.

No. The bond holder has exchanged an asset (long term Govt bond) into money. In normal situations he deposits that new money into his bank account, which money can be lent and re-lent, expanding the dollar amount of deposit accounts.

The fact that the holder as given up a bond is not a counterbalancing affect against inflation, because government bonds are not money.

 

If the Fed simply just created money and gave it out for free, you would be right. But it uses the money it creates to add to its reserve assets.

In one sense, the reserve assets are backing the dollar.

If you have a mortgage, the Fed might be the one who ultimately holds the equity in your house, for example.

 

I'm not sure what you mean by the Fed's "reserve assets"? Reserve assets in my experience usually refer to assets a bank holds that count towards its reserve requirements.

But I don't understand how the fact that the Fed buys assets creates more demand for money.

I know people think that from watching internet videos. They think that the value of the dollar is somehow directly tied to the Fed's assets. But not really. The value of the dollars in the economy are based on the supply and demand for the money, and backed up by the full faith an credit of the United States. The assets the Fed holds don't directly affect the value of a dollar. However, as we've previously discussed, those assets are the primary mechanism by which the Fed reduces the amount of dollars in the economy, so if they were completely dissipated, it would affect the Fed's ability to control the money supply.

Or more precisely the security for the loan which would be the equity in the house.

Unlikely, but so what? How does that create demand for money?

 

If.... the central banks of the USA and Canada are forced to keep interest rates low.........
(interest rates are one significant factor in real inflation).......
then rates of inflation can be low but.........

.... when Big Banks convince astonishingly naive "economists" that high rates of interest are the best way to fight inflation.........

then the fractional reserve system can become extremely inflationary.........

https://www.michaeljournal.org/arti...ce-our-country-debt-free-say-three-economists

 

obviously it could cause 100000000% inflation if the expansion was great enough. So?????

 

If you borrow money from the Fed, you have to at some point pay it back. Money is added into the system, but there's also a expectation for the future that money is going to be taken out of the system. If you had double the money, but knew you were going to have to pay half of it to someone else, would you still spend as if you had all of that money?

I'm just pointing out that more money does not necessarily lead to more inflation if the money does not become worth less. When you simply throw money at people, yes, it does become worth less. But when you put further constraints on people and start demanding more money out of them, it counterbalances the effect of inflation. People need money to repay their loans and pay taxes.

 

Borrowing money from the Fed is not what we are talking about. We're talking about "the money it creates to add to its reserve assets." It does that by buying assets (usually Govt bonds) in the open market.

The Fed does make loans, but they are limited and usually short term and not the principal way it creates money.

So you haven't addressed my question: When the Fed buys and asset and injects new base money into the money supply, how does that create demand for money?

Depends on the terms. But what expands the money supply is depositing the money in a bank, assuming banks are lending.

I agree that having more base money does not necessarily lead to more inflation. But it's not based on the money's worth, but whether the money is lent out by banks and spent.

 

Well, a lot of those assets are debt. So it's the same thing.
But even if we are not talking about those assets being debt, it's a very similar principle.

View it as a long-term loan.
For example, when the Fed expands the money supply to buy Treasury debt, you're going to eventually (at some point in the distant future) have to be taxed to pay back that debt.

The government has thrown money at you, but you know it's also going to demand that money back.
(That example is very theoretical of course because it's doubtful people realize how much they are going to have to be taxed in the future)

There's less of a tendency to spend it because people know they are going to have to pay it back at some point.

Because that money is going to have to paid back at some point, or because people will want that money in the future to be able to get their hands on the Fed's assets, if there is ever a contraction of the money supply at some point and the Fed sells off some of its assets.

 

Not quite. When the Fed purchases an asset, it increases its own assets. With a loan, the Fed is not purchasing an asset.

Generally the assets the Fed purchases are long term US Govt debt. It may not have a maturity date of many years. So there is no immediate need for money to pay the debt back. And even when the debt matures, the Fed (assuming it does not want to reduce the money supply) will just roll over the debt with new debt.

So there really is not countervailing demand for money created.

 

One person's asset is another person's debt.

The Fed buys loans. They own debt, from banks and from the U.S. Treasury.

In the old days, every person who owned a bank note theoretically owned a stake in that bank's reserve assets. In a very abstract theoretical way, the same principle applies today. The U.S. dollar is analogous to a bank note from the Fed.

 

True, but at some point there is going to be a need.
If the Fed decided right now it would not cause any more inflation, and the government decided to start paying down its debts, it would probably start causing some serious deflation.

In reality, that's unlikely to happen, because the Fed will expand the money supply and dilute the worth of the dollar (real inflation) to prevent that from happening. That will mean deflation will not seem to show up.

But it's not exactly a free lunch because that will just solidify all the inflation that has apparently been happening over the years. And of course it will also eat into the government's purchasing power. Otherwise they might have been able to lower taxes.

 

Not necessarily true at all.

Just as I said, usually long term Govt debt.

Not really. Having a dollar gives you no right to exchange it for some specified amount of an asset, like gold.

Not sure what any of this has to do with creating demand for more dollars.

 

Not necessarily. The Fed can (and does) simply roll the asset over for a new asset.

Last I checked, the Fed held 10-15% of the outstanding public debt. So the US government would have to pay down a *lot* of its debt before that happened.

And the Fed could always replace it would other assets.

In the unlikely event the US Govt paid down so much of its debt that its started affecting the Fed's ability to acquire US bonds, it could simply buy other assets. It doesn't have to dilute the worth of a dollar at all.

None of that makes any sense at all.

 

free lunch for who? if its free to the taxpayer the govt pays it, if its free to govt the taxpayer pays for it. THere is no free lunch. Economic growth from stone age to here is caused by inventions in environment of no inflation or deflation.

 

Fractional Reserve Banking has been around for hundreds of years all over the world in all countries and all currencies, so the real questions here are "is the money supply growing and is it causing inflation?"

The answers are yes, the money supply's been expanding for decades and no the rate of inflation's been falling for decades. There are a lot of econ textbooks that say bigger MS = inflation, but they always limit this by mentioning money velocity. Since 1980 MV's been falling big time; iow there may be more dollars around but folks just aren't spending 'em.

 

Is fractional banking inflationary? No, not intrinsically as I think OP imagines, although it could be manipulated to be hugely inflationary or deflationary.

 

Yes, fractional reserve banking increases the money supply, hence it is inflationary.

 

it doesn't inherently increase or decrease money supply as if there were no controls any more than totally govt free banking would be inflationary