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Is Fractional-Reserve Banking Inflationary?

by George Selgin September 2nd, 2011 10:51 am

(This is another piece originally written for the now-defunct Free Market News Network. Although the piece is mainly aimed at "Rothbardian" claims to the effect that fractional-reserve banking is inflationary, advocates of free-banking are sometimes also guilty of exaggerating the influence of banking-industry structure on inflation, as some do, for instance, by suggesting that bank deregulation alone will serve to combat inflation. Generally speaking, an economy's rate of inflation is mainly a function, not of the reserve ratios kept by its banks or of whether banking is a free or heavily regulated industry, but of the nature of it's base money regime.)

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Certain economists of the Austrian School, and followers of Murray Rothbard especially, oppose fractional reserve banking for at least three reasons. They claim that banks resorting to it defraud people, that they bring about business cycles, and that their activities cause inflation. This article addresses the last claim only: I hope to discuss the others separately.

The “Rothbardians,” as I’ll refer to them, recognize two distinct meanings of the word “inflation.” One meaning—which they prefer—defines it as any increase in the nominal stock of money, including fractionally-backed bank deposits and notes (which they, following Ludwig von Mises, prefer to call “money substitutes”). The other, which is in common use today, defines it as any ongoing increase in the general level of prices, that is, as a positive rate of change in one or more broad price indexes, such as the CPI. In calling fractional reserve banking “inflationary” Rothbardians often seem to have the latter, more conventional definition of inflation in mind, and my arguments are mainly aimed at responding to their complaint so interpreted. However, in doing so, I also hope to clarify the extent to which fractional reserve banking does or doesn’t promote “inflation” in the less conventional and more strictly Rothbardian sense of encouraging growth in the (broad) money stock.

Perhaps the simplest way to assess the price-level consequences of fractional reserve banking is to first imagine an economy in which such banking is prohibited, as many Rothbardians insist it ought to be. Such an economy would admit 100-percent reserve or “warehouse” banks only. To simplify the comparison further, let’s assume that all exchanges are conducted using warehouse bank certificates: in other words, the reserve medium itself—let’s assume it’s gold—doesn’t circulate. The price level adjusts so as to equate the supply of and demand for gold, including bank reserves.

Assuming fixed levels of demand for both money and non-monetary gold, there can be no inflation in this system, in either sense of the term, so long as the gold stock also remains unchanged. That stock could increase, however, as a result of gold mining. For the sake of argument, though, let’s assume that available gold mines have all been exhausted, and that no new discoveries are forthcoming. By assuming that available gold is not consumed—in the sense of being gradually used up—by industry, we can rule out deflation as well.

Suppose next that fractional reserve banking is legalized and that, Rothbardian warnings notwithstanding, it becomes so popular that all the old warehouse banks embrace it. Will inflation result? Of course it will—but only for a time. As fractionally-backed notes (or deposit credits) take the place of their 100-percent reserve predecessors, the demand for monetary gold, and hence the demand for gold in general, declines, causing the value of gold to decline with it. Because prices are expressed in terms of an (unchanged) gold unit, the price level has to rise. But as the demand for gold doesn’t drop to zero—banks still hold some reserves, and there is still a non-monetary demand for gold—the price level eventually reaches a new equilibrium. All this assumes, by the way, that the switch to fractional reserves is worldwide: if the switch was limited to a single, small country, then banks in that country would export their unneeded gold reserves to the rest of the world, and worldwide price level changes would be negligible.

The overall extent of the increase in prices, and of the underlying expansion of fractionally-backed bank money, will depend on the reserve ratio banks settle on. The lower the ratio, the higher the rise in prices. But whatever the ratio turns out to be, the system will eventually reach a point at which inflation ceases. The move to fractional reserves results, in other words, in a permanent, once-and-for-all price level change, but not in any permanent change in the inflation rate.

What’s to keep the banks from further reducing their reserve ratios? The answer is that, so long as they all compete on an equal footing, as in a free banking system, each will be inclined to routinely return claims, such as checks or banknotes, received from rival banks. The uncertain flow of such interbank “clearings” generates a demand for reserves for settlement, which (in the presence of positive costs of default) will vary with the volume of outstanding bank liabilities, even if bank customers never bother to withdraw gold. Although optimal reserve ratios are unlikely to remain perfectly constant over time, and may decline gradually as more efficient settlement procedures are discovered, for the most part the rate of inflation under an established and mature fractional reserve arrangement is unlikely to differ substantially from the rate that would prevail under 100-percent reserves.

Admittedly this conclusion depends on the assumption of an unchanged real demand for money. If the demand for money grows over time, as it does in most healthy economies, that growth will in fact have different implications for inflation under the two regimes. Yet it still won’t promote inflation in either case. On the contrary: in the 100-percent reserve case, growth in money demand must cause prices to decline at a roughly corresponding rate (“roughly” because there may be some shifting of available gold from non-monetary employments to bank reserves). Under fractional-reserve banking, in contrast, there will be greater scope for monetary expansion, depending on how free banks are from legal impediments. Under free banking, for example, banks can “stretch” their reserves somewhat as the demand for money increases, provided that the increase takes the form of a fallen velocity of money. This happens because the fall in velocity translates, ceteris paribus, into a fall in both the volume of bank clearings and the demand for reserves. In other words, in the presence of economic growth, a free fractional-reserve banking system, although it won’t promote inflation, will be somewhat less deflationary than a 100-percent reserve system.

If fractional reserve banking isn’t to blame for inflation, what is? Inflation could break out because of new precious-metal discoveries, or cheaper means for extracting metal from existing mines. Experience suggests, though, that metal-driven inflations aren’t likely to be serious. The California gold rush, for instance, barely caused a blip in most measures of the price level (the monetary expansion it sponsored was quickly overtaken by offsetting growth in money demand). Likewise, the so-called “price revolution” of the 16th century—a quadrupling of European prices that was at least partly due to the inflow of gold and silver from the New World—translated into an average annual inflation rate of below two percent. Of course even normal gold production will tend, other things equal, to raise prices, but industrial consumption and secular growth in money demand will have the opposite effect. In the long-run, if history is any guide, these forces will tend to cancel out—and will do so whether banks hold fractional reserves or not.

Responsibility for really serious inflations belongs, with only rare exceptions, to central banks, and especially to central banks (or other government agencies) that issue irredeemable fiat money. The monopoly privileges central banks enjoy, and their monopolies of paper currency in particular, give them much greater powers of monetary expansion than ordinary commercial banks enjoy, by freeing them from the discipline of routine clearing and settlement. Because other banks are denied the right to issue their own notes, they treat central bank notes as reserve assets—and will tend to do so even under a gold standard. The central bank is then free to expand—and to encourage other banks to expand with it—until inflation proceeds to a point where gold can be had more cheaply by cashing in its notes than by buying it in the open market. A central bank that issues inconvertible fiat money can, of course, expand without running into any material checks. It is no coincidence that all of the world’s great inflations have taken place in fiat money regimes.

The claim that fractional reserve banking as such is inflationary is unfortunate, not merely because it is theoretically as well as factually wrong, but also because it diverts attention away from central banks and government authorities—the real culprits behind any serious inflation—while pointing a finger at ordinary commercial bankers, who are at most guilty of making use of new reserves that central bankers generate. In this way Rothbardians unwittingly give credence to central bankers’ claim that inflation isn’t their fault: that its cause rests in private-market developments that they—“inflation fighters” all—are doing their utmost to combat.

So it’s time to dump the rhetoric linking inflation to fractional reserves. Fractional-reserve banking may have its drawbacks, but a tendency to fuel inflation isn’t one of them, and the chief beneficiaries of claims to the contrary are none other than the world’s central bankers and their apologists.

30 Responses to “Is Fractional-Reserve Banking Inflationary?”

  1. avatar robread says:

    Great article !

    I have a question that is slightly tangential to the post but is of great interest to me.

    George writes that 'banks can “stretch” their reserves somewhat as the demand for money increases, provided that the increase takes the form of a fallen velocity of money. This happens because the fall in velocity translates, ceteris paribus, into a fall in both the volume of bank clearings and the demand for reserves. In other words, in the presence of economic growth, a free fractional-reserve banking system, although it won’t promote inflation, will be somewhat less deflationary than a 100-percent reserve system.'

    I understand how this mechanism works. It strikes me however that the fall in velocity could often be due to an economic shock (threat of war or natural disaster, disrupted supply of major raw material etc ) that could lead to the decline being sharp. Is it realistic in these circumstances that banks will increase lending even though they would have spare reserve capacity ? Would FRFBs reserve requirements factor in such things as riskiness of potential returns that might counter the stabilizing effect on the money supply that is described in the quote ?

    Thanks for any help understanding this.

    • avatar George Selgin says:

      It isn't so much the "sharpness" of a decline in V that matters; it is whether other determinants of banks' optimal reserve ratios are also changing. One such factor, of course, is the perceived risk-adjusted return on other assets.

      I cannot grasp however what "spare reserve capacity" means in a free banking context. The notion of "spare" or "excess" reserves applies only w.r.t. the existence of some legal reserve requirement. In this sense all free bank reserves are "spare" or "excess" reserves. But they are not excessive relative to the banks' own determination of their needs.

  2. avatar Rob R. says:

    I used "spare reserve capacity" incorrectly - what I meant the extra funds they would have had to lend out following an increase in their customer cash balances if they had kept the same method of determining reserve ratio as before.

    To put my question rather more directly: Are there any scenarios where because of changes to perceived risk-adjusted returns (or other factors) FRFBs may reduce rather than increase their loans in the face of increased demand for money? If yes, would you see this as a very likely scenario to occur in a free banking world ?

  3. avatar Mike Sproul says:

    Suppose that gold is base money, and that a central bank issues 100% reserve dollar notes (base money) convertible into that gold. Then private banks issue fractional reserve dollars (notes, deposits, or both) that are convertible into the base notes. The fractional reserve dollars are call options on the base dollars. Basic option pricing theory says that the issuance of call options will not dilute the base security, and thus will not change its value. So when you say: "Will inflation result? Of course it will—but only for a time." You are at odds with option pricing theory.

    It is possible, as you say, that the issuance of the fractional reserve dollars can affect the liquidity demand for gold and thus reduce its value. But suppose that the quantity of base money is so small that there is no liquidity premium on gold. In that case, the issuance of fractional reserve dollars will not affect the value of either the 100% reserve dollars or the gold. The move to fractional reserve money would not even cause that "only for a time" round of inflation.

    • avatar George Selgin says:

      Mike, there's no violation of option theory in my example. The creation of preferred substitutes for gold lowers the demand for the real McCoy, and so lowers the value of the standard gold unit in equilibrium. Of course if monetary demand for gold was a small part of the total stock demand, the amount of inflation will be correspondingly low. But I never said there's be a lot of inflation: I merely said there's be some.

      • avatar Mike Sproul says:

        George:

        We're in agreement so far. If monetary demand for gold is negligible, then the creation of fractional reserve money, either by the central bank or by private banks, is not inflationary. But now suppose that the base money is the Fed's paper dollars themselves. Those who think the paper dollars are fiat money would have to say that they have value because of monetary demand for them, and this implies that the creation of fractional reserve money convertible into those paper dollars (call options on the base money) will cause inflation. In other words, they claim that the issuance of call options dilutes the base security and does cause inflation.

        The alternative is to recognize that the dollar is not fiat money, and that its value comes from its backing, not from monetary demand for it. Once that is understood, it is clear that the issuance of calls on the base money does not dilute the base money and does not cause inflation. This is why the introduction of checking accounts, credit cards, eurodollars, etc. has actually contributed nothing to inflation, even though believers in fiat money have often disagreed.

        • avatar George Selgin says:

          Mike, my argument applies mutatis mutandis to fiat money: if you start with 100% fiat M, then the introduction of fractional reserves can be said to lead, other things equal, to a one-time inflation that reflects either the reduced demand for base money or if you prefer0 the increased supply of broad money. The principles remain the same as before. It is absurd to imagine that, if we go from a world in which only FR notes can be used to buy stuff, to a world in which commercial banks can create all sorts of substitute exchange media, the real equilibrium value of a FR$ will not be affected.

          As for your suggestion that the value of a fiat base money depends on what 'backs' it, I think this one of the cruder fallacies of monetary economics. Fiat money derives its value not from the assets backing it but from the limited quantity confronted with the demand for the reserve medium.

          I also agree with Bill Step that a redeemable claim isn't the same as a "call option."

          • avatar Mike Sproul says:

            George:

            So if gold has, say, a 20% monetary premium, then you'd say that the introduction of fractional reserve banking could cause roughly a 20% inflation, as gold's monetary premium was competed away by fractional reserve moneys. But fiat money has a 100% monetary premium, so the introduction of fractional reserve money in this situation could cause fiat money to lose all its value. Or if banks kept 1% reserves, the money could lose 99% of its value. This makes fractional reserve banking tantamount to counterfeiting, just as Rothbard said. It also creates a profit opportunity for arbitragers, who would sell dollars short and profit from the inflation resulting from the spread of fractional reserve banking. (By the way, selling dollars short, i.e., borrowing dollars and selling them, creates new dollars. Thus you get the weird result that short sellers profit from the very inflation that they cause.)

            I doubt that you'd dismiss the backing theory in the case of a money that is convertible into gold. If each dollar is a convertible claim to 1 oz. of gold, then as long as the issuing bank has sufficiently positive net worth, it will always be able to buy back each dollar either for 1 oz. of gold directly, or with assets that trade in the market for 1 oz. Money, in this case, is valued just like stock, or any other liability.

            If convertibility is then suspended, like the Bank of England did in 1797, then does the money suddenly switch from being backed to being fiat? And if they resume convertibility 24 years later, does the money switch from fiat to being backed again? The sensible answer is that the bank's assets were there all along, so the money was backed all along. The 'fiat' designation comes from people who mistakenly think that 'inconvertible'='unbacked'.

        • avatar Martin Brock says:

          Fed money is "fiat money" not because it unbacked, or because it has value only as a monetary medium, but because it is backed by obligations imposed upon taxpayers by Congressional fiat. Congress is the monetary authority, not the Fed.

          Money under a gold standard (bank notes promising gold) is "gold backed" because note holders may exchange their notes for gold. The corresponding transaction in the Fed system is an open market operation in which a dollar holder exchanges his dollar for a U.S. Treasury security at a price established by the Fed.

          All Treasury securities are not the same, of course, so the Fed may control more than one Treasury price, but I'll discuss a single price for the sake of simplicity, for the sake of comparing the current system to a gold standard.

          The Fed also establishes the Treasury price by fiat and may vary it as a regulatory policy, but the "fiat" in "fiat money" refers primarily to the imposition of these obligations to pay taxes and other rents in dollars (in my way of thinking of course). Varying this price continually raises fewer eyebrows than varying the established price of gold under a gold standard.

          I deal in dollars because I must pay taxes in dollars, and I hold Treasury securities because the Congress promises to pay principal and interest on my Treasury securities by collecting dollars from others dealing in dollars for the same reason.

          • avatar Mike Sproul says:

            Martin:

            Excellent post! An analogy I like is that the government is like a landlord who collects rent, and sometimes pays his bills with bits of paper that he promises to accept in payment of rent. People find those bits convenient as money. The bits are backed by rents receivable in the same way that paper dollars are backed by taxes receivable. Colonial American currency was backed in the same way. Nowadays we've added bonds to the picture, so that dollars are backed by bonds, which are backed by taxes.

          • avatar Martin Brock says:

            Of course, I'm not defending state money, only discussing it. I don't defend it. I don't want the Congress to be a central monetary authority, but I can't deny that it is one. I don't want any central monetary authority at all.

            I want to start completely over with monetary authority as decentralized as possible, and I then want people to construct credit insurance arrangements through free association, from the bottom up. I do not want radical reform through the political process. Individual entrepreneurs start the ball rolling, and others join the game if they like what they see.

            That's the way of the market, and it's the only way that monetary reform in a free market direction can succeed ultimately in my opinion. Any top down reform of the current system in a "market direction" is doomed to fail. Plentiful evidence of this failure already exists.

            Anyone truly interested in free banking should not be running for office or conferencing with Ben Bernanke. He should be launching an entrepreneurial venture. I support Ron Paul, but I support him as a candidate for Commander in Chief of the Armed Forces, not Commander in Chief of the Monetary System or the Economy more generally. As long as we think of the head of state this way, we might as well elect Mussolini.

  4. avatar Martin Brock says:

    Credit leveraging a standard commodity is not generally inflationary assuming that demand for the commodity relative to other goods is stable and assuming that lenders overextending credit are allowed to suffer default. A statutory "lender of last resort" with extraordinary authority to issue notes promising the standard (or to create a fiat standard itself) seems likely to violate the second assumption. I can't argue with this reasoning.

    Outside of the Rothbard followers, opposition to a gold standard focuses more on the first assumption and fears deflation more than inflation. Demand for the standard can increase, requiring a systemic, deflationary unwinding of credit. This increased demand can be essentially irrational, like the mania for tulip bulbs. It's a "panic", a "run on the banks". A lender of last resort is supposed to innoculate the monetary system against this irrational mania and other transitory changes in demand for the standard.

    I lack your historical knowledge, but the more conventional opponents persuade me. At the moment, "We Buy Gold" signs are popping up everywhere. Some gold buyers even employ people to stand along the street waving these signs. Demand for gold apparently has changed. I didn't see so many of these signs a few years ago. The price of gold has risen precipitously, and these signs certainly look like a mania for gold. If a similar mania for gold occurred under a gold standard, a systemic unwinding of credit would also occur, and the unwinding would be deflationary. Wouldn't it?

    The conventional reasoning seems less an argument against free banking than an argument against leveraging gold to extend credit. It's an argument against a particular standard of value, not against a general principle of free banking. Rather than a central bank, we want a standard of value more naturally immune to the ills of a mania for the standard. Don't we?

    The problem with gold is that it can be hoarded. Right? Possession of gold can become concentrated, either directly in the hands of the most central authorities (as at Ft. Knox) or in the hands of their title holders. If gold is a legal tender, if a state continually draws it forcibly from circulation through taxation and then redistributes it through state spending, this outcome seems all the more likely.

    What is wrong with this reasoning?

  5. avatar Bill Stepp says:

    Fractional reserve dollars are not a call option on base dollars. A call option gives the owner the right to buy an underlying asset (e.g., a stock or commodity) at a fixed price before it expires. It's a wasting asset, and declines in value until its expiration at which time it has no value.

  6. avatar Bill Stepp says:

    It's not an (call) option according to the standard definition:

    An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

    That's from SPDR University.
    I doubt Larry McMillan, who wrote the book on options, would agree with you.

    • avatar Mike Sproul says:

      A checking account dollar gives its owner the right, but not the obligation, to buy a paper dollar for a price of zero on or before the time that the bank folds. If a date of 1/1/9999 were set, that would match your definition exactly.

      Aside from semantics, the important point is that the issuance of a checking account dollar does not dilute the base security, which in this case is the paper dollar.

      • avatar Martin Brock says:

        After some thought, I almost agree with you here but not quite. A check seems to be the pre-Net equivalent of a debit card. When I write a check, I don't option an asset recorded in my bank account. I actually transfer the title. If the check is never cashed, I never actually lose possession of it, but this sort of thing can happen with any transfer of title.

        For example, I sell you my house for a chest of gold. I sign the title over to you, but you're struck by lightening on your way home, and the record of title transfer burns. No one else was aware of the transaction, and I never tell anyone. I just remain in the house with the gold. If you die without heirs, only the sovereign loses, and who cares about his losses anyway?

        A debit card only makes this forgetting of a title transfer less likely, because the Net instantaneously records the transfer in a centralized repository.

        Still, I see your point about the similarity between a check and an option on a dollar that never expires. Promissory notes seem a bit like options, but I doubt that options pricing theory applies as you suggest. I suppose for example that the theory presumes a sort of equilibrium that does not exist initially in George's hypothetical.

        • avatar Mike Sproul says:

          Martin:

          A call option with a strike of zero and no expiration date is usually called a hypothecated share. It is just an IOU, usually issued by a short seller, that promises delivery of a genuine share (for free) at some arbitrary future date. So a checking account dollar could be called a hypothecated dollar without running afoul of George and Bill's definitions. The point remains that the issuance of a hypothecated share or dollar does not dilute the underlier.

          • avatar Martin Brock says:

            Does this option (hypothecated share) have a date before which I may not exercise it?

            Since the strike price is zero, what do I pay for the option? If I may exercise the option immediately, don't I pay the price of the underlying asset?

            When you sell me this option, you effectively the transfer of title to me. If I don't immediately exercise the option, I let you rent the asset from me, with a rent of zero, for an unspecified time.

            If lots of people buy this asset and lower the rent to zero, doesn't that dilute the asset?

          • avatar Mike Sproul says:

            Martin:

            If Merrill Lynch issues a hypothecated share of GM stock (an IOU promising free delivery of 1 share of GM at any time), there is usually no date restriction. Of course, this depends on the contract.

            If a genuine share of GM sells for $60, the hypothecated share will also sell for $60.

            If Merrill issues and sells a hypothecated share for $60, then Merrill's assets rise by $60 at the same time that Merrill's liabilities rise by the hypothecated share (originally worth $60). Note that GM's assets and liabilities are unaffected by Merrill's activity. That's why genuine GM stock is not diluted.

            If Merrill earned interest in excess of its transaction costs, then that would attract other brokers to issue shares that paid less interest, until that interest premium was competed away.

          • avatar Martin Brock says:

            You seem to be assuming that holding the share of GM, before someone exercises an option to buy it at $60, is of no value to Merrill, but I'm not sure that's true. If GM pays a dividend before someone exercises the option, Merrill would receive the dividend, right? This dividend is not a transaction cost.

            What do I get out of holding the option rather than the share?

          • avatar Mike Sproul says:

            Martin:

            Dividend payments are covered differently in different contracts, but a common arrangement would be for Merrill to agree that whenever GM pays a $5 dividend to the holder of a genuine share, Merrill will pay $5 to the holder of Merrill's IOU.

            In this case, people would be indifferent between holding the genuine GM share or the IOU.

          • avatar Martin Brock says:

            An option offering every advantage and disadvantage of owning the underlying asset is an "option" in name only.

  7. avatar Bill Stepp says:

    In the real world, the only goods with a price of zero are so-called "free" goods (like air), subsidized goods (like water in much of the world), and gifts (to the recipient). Priceless does not mean costless though.
    An option with a price of zero is not an option, so there can be no violation of option pricing theory.
    You are playing semantic word games that have nothing to do with reality.

  8. avatar Paul Marks says:

    Fractional Reserve Banking.

    It depends what is meant by it.

    If what is meant is that a "bank" (or some other money lender) lending out a "fraction" (say nine tenths) of the savings entrusted to it, then NO "fractional reserve banking" is NOT "inflationary".

    However, if by "franctional reserve banking" it is meant that (by various book keeping tricks) the banks lend out MORE money than there is real savings (i.e. the create "new money") then it is inflationary - but only for awhile.

    This is because such a bank credit credit bubble does increse the money supply (i.e. "broad monet", bank credit, becomes bigger than the monetary base it is "built upon"), but only during the "boom" period. When the inevitable "bust" comes and (this form) of fractional reserve bank goes bankrupt, the credit bubble malinvestments are liquidated and broad money goes back down towards the monetary base.

    So, BAR GOVERNMENT INTERVENTION, any inflationary effect of fractional reserve banking (even fractional reserve banking that seeks to "create money") is only temporary.

    Historically this can be seen in the history of the United States and many other nations - banks (by using book keeping tricks) increase the amount of money they lend out (beyond the level of real savings that went into them) thus "increasing the money supply" (of broad money - bank credit), but when the bust comes (as it inevitably does) the "broad money" supply shrinks down again.

    Unless there is government intervention.

    • avatar George Selgin says:

      It depends what is meant by it....If what is meant is that a "bank" (or some other money lender) lending out a "fraction" (say nine tenths) of the savings entrusted to it, then NO "fractional reserve banking" is NOT "inflationary".

      However, if by "franctional [sic] reserve banking" it is meant that (by various book keeping tricks) the banks lend out MORE money than there is real savings (i.e. the create "new money") then it is inflationary - but only for awhile.

      Paul, this attempt to make the answer to my title question a matter of definitions, and therefore 'obvious," is invalid. The definition of fractional reserves is not controversial: it means that base-money reserve assets are less than 100% of demand liabilities. Your own peculiar definitions made answering my title question easy by essentially reasoning in a circle: if we define FR banking as non-inflationary banking, it won't cause inflation etc. That's hardly helpful.

      And inflationary lending needn't be the result of any "book keeping trick." It can happen as a result of an innovation that reduces the need for reserves for settlement, for instance, or simply as a result of the "invention" of bank money.

    • avatar George Selgin says:

      It depends what is meant by it....If what is meant is that a "bank" (or some other money lender) lending out a "fraction" (say nine tenths) of the savings entrusted to it, then NO "fractional reserve banking" is NOT "inflationary".

      However, if by "franctional [sic] reserve banking" it is meant that (by various book keeping tricks) the banks lend out MORE money than there is real savings (i.e. the create "new money") then it is inflationary - but only for awhile.

      Paul, this attempt to make the answer to my title question a matter of definitions, and therefore "obvious," is invalid. The definition of fractional reserves is not controversial: it means that base-money reserve assets are less than 100% of demand liabilities. Your own peculiar definitions made answering my title question easy by essentially reasoning in a circle: if we define FR banking as non-inflationary banking, it won't cause inflation etc. That's hardly helpful.

      And inflationary lending needn't be the result of any "book keeping trick." It can happen as a result of an innovation that reduces the need for reserves for settlement, for instance, or simply as a result of the "invention" of bank money.

  9. avatar Paul Marks says:

    Almost needless to say....

    By "inflation" I mean an increase in the money supply - not an increase in the "price level" idea so beloved Fisher (of Yale) and other such.

    By the latter ("price level") definition the late 1920s and even the 2000s were not an inflationary period - and the economic damage done by the real (money supply increase) inflation, goes unnoticed (till the inevitable bust).

    What Franctional Reserve Banking does (IF we are using the definition of FRB that means that the banks lend out more than the real savings that actually went into them - NOT a "fraction" of the real savings that went into them) is to increase bank credit ("broad money") beyond that part of the monetary base that (as real savings) went into them, thus incresing the de facto money supply - it is "inflationary" BY DEFINTION, but only for a temporary period.

    Eventually the "bust" comes and the credit money bubble is liquidated (i.e. the money supply falls back down towards the monetary base), even if the banks themselves manage to escape bankruptcy.

    Again, the above (the temporary nature of the inflationary effect of this form of FRB) depends on no government interventions to try and maintain the credit bubble economy.

  10. avatar George Selgin says:

    "Almost needless to say....By "inflation" I mean an increase in the money supply - not an increase in the "price level" idea so beloved Fisher (of Yale) and other such."

    It most certainly does need saying, as I expressly use the other, standard definition in posing the question. Here again, you turn a substantive question into a meaningless one by toying with definitions.

    As for defining inflation to mean an increase in M, rather than in P, it is a tedious practice, encouraged by Rothbard, that merely confuses people. Like it or not, inflation has meant rising prices to several generations of economists by now. Language evolves: it's time for Austrians to accept this!

  11. avatar Bill Stepp says:

    To be as fair as one can be to Rothbard, he says in Man, Economy, and State that the supply and demand for money determine its purchasing power (PPM). So an increase in the money supply that were offset by a decline in the demand for money could leave its purchasing power unchanged.
    I've always found the "price level" to be a slippery concept, but that's probably my fault.

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