How does fractional reserve banking increases money supply?

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vassy
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How does fractional reserve banking increases money supply?

Post by vassy » 25 Jul 2017 17:00

Hi,
I read that fractional reserve banking increases money supply in the economy. Suppose reserve ratio of a bank is 10% and I deposit $100 into the bank. The bank can then set aside $10 and lend remaining $90 to person A. Now person A has to repay $90 + some interest. Where is the money for person A going to come from? Assuming there was just $100 bill in the economy. How is person A going to repay his loan? Where does this extra money gets generated?

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Re: How does fractional reserve banking increases money supply?

Post by longinvest » 25 Jul 2017 17:05

How the Bank of Canada Creates Money for the Federal Government: Operational and Legal Aspects
However, it is important to note that money is also created within the private banking system every time the banks extend a new loan, such as a home mortgage or a business loan. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money (see Appendix B). Most of the money in the economy is, in fact, created within the private banking system.

A key similarity between money creation in the private banking system and money creation by the Bank of Canada is that both are realized through loans to the Government of Canada and, in the case of private banks, loans to the general public.

One difference between the two types of money creation is that there is no external limit to the total amount of money that the Bank of Canada may create for the federal government. In contrast, the amount of money that a private commercial bank is permitted to create depends on the amount of the bank's equity relative to its assets. The limiting rules, known as "capital constraints," are set by the banking regulator in guidelines. Another difference is that the creditworthiness of the borrower is the key factor in the decision by a private commercial bank to provide a loan to a private entity, while this is not a factor in the Bank of Canada's decision to lend money to the government.
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Re: How does fractional reserve banking increases money supply?

Post by longinvest » 25 Jul 2017 17:16

vassy wrote:
25 Jul 2017 17:00
Where is the money for person A going to come from? Assuming there was just $100 bill in the economy. How is person A going to repay his loan? Where does this extra money gets generated?
Money is just a medium of exchange. Real wealth is the important thing.

For example, I can create a product. By doing so, I've created wealth. This wealth can be converted into money: I can sell it and get money for it.

A personal loan uses wealth creation ability of the borrower as collateral (e.g. his ability to get a job and be paid for it, or something like that).
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Re: How does fractional reserve banking increases money supply?

Post by longinvest » 25 Jul 2017 17:26

We often hear about "good debt" and "bad debt". The idea is pretty simple. As a debt must be repaid with interest, a good debt is a debt where the money is used for creating new wealth. For example, one could use debt to buy the tools and materials to build a house. When the house is sold, it is anticipated to be worth more than the cost of the tools, materials, and work to build it. Part of the profit from selling the house will serve to pay the interest on the loan.

Bad debt is a debt which doesn't serve to create new wealth. It's usually called consumption debt. It simply serves to pay for goods, today, with future salary. It results into paying more to consume today (because of the interest). Yet, it is helpful for the economy: it gets people to consume more, leading to more wealth creation by wealth creators in order to fulfill the demand for goods to consume. It is also a very lucrative business for our banks.

So, is bad debt really bad? It depends if you're the one paying the interest, or the one benefitting from others who borrow to consume.
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Re: How does fractional reserve banking increases money supply?

Post by ghariton » 25 Jul 2017 18:44

I agree with almost all that longinvest wrote :wink:

The characterization of good and bad debt in terms of vale-added works well for enterprises, but less well for households. About the only "productive debt" incurred by individuals and households is borrowing toward education and other increases in human capital. For households, we need another concept of good debt, i.e. debt that smoothes out consumption over one's lifetime. Borrow when you are young with little money, build up assets during your working years to pay off the debt and accumulate retirement assets, then decrease them to zero (plus a safety buffer and legacies) in your old age. The borrowing in the first stage would be good debt, according to this.

Of course, this principle can be abused. Borrowing can be habit-forming, and paying off the debt may not happen, or may not happen quickly enough. But I think that the principle itself remains valid.

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Re: How does fractional reserve banking increases money supply?

Post by vassy » 25 Jul 2017 21:42

Hi,

Thanks for your replies. I haven't still figured this out. So, person A (mentioned in the question) takes the loan and builds a product. Now he has to sell that product. Money for that product is eventually going to come from the bank in which other people have deposited money. So, this wealth creation (building of the product by Person A) is not real money. Money is generated only when Federal Reserve prints it. Right? So, my point is wealth is getting created in this process (which is person A's product) but money is not. Money is generated only by Federal Reserve.

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Re: How does fractional reserve banking increases money supply?

Post by longinvest » 26 Jul 2017 00:05

vassy wrote:
25 Jul 2017 21:42
Money is generated only when Federal Reserve prints it. Right?
No. You and me could create money out of thin air, if we wanted. Here's how it would go. We would charge each other $5 to answer a question. The thing is, we wouldn't pay the other immediately; we would just keep a record of the debts.

For example, if I asked you a question and you answered, I would owe you $5. We would write that in a register. There you go: $5 have just been created out of thin air. A few days later, you ask me a question and I answer. You would now owe me $5, too. We're up to $10! We could agree to settle our debts, right then, as they would be equal (assuming no interest was charged). And the $10 would be destroyed in the process. As for the wealth, it remains; we both have acquired new knowledge!

Where we could eventually get into trouble, is that Canadian and provincial laws have strict rules on such transactions; taxes have to be paid. We need to generate more money to pay those taxes... Luckily, companies pay taxes on profits; not gross revenues! In our case, our respective profit is probably $0, so no taxes would need to be paid (but, there might be business registration fees, etc.). Note that this is why we couldn't just count our debts using any kind of currency such as apples, gold, or bitcoin; the law forces us to keep clear records in terms of the official currency: the Canadian dollar.

Of course, people prefer to exchange "real money", instead of relying on private debt recorded in a book. That's where the banking system gets in and helps us. But, the money was really created as a result of a service exchange. The rest is mostly bookkeeping, with the help of banks. If I'm not mistaken, for every dollar created in a record, there's an equivalent debt of one dollar created in a record. I really prefer to think in terms of wealth, instead of money, though.

The nice thing is that money is not needed to create wealth, just to exchange it. Unfortunately, wealth can be destroyed, too, without having actual money disappear. Take a house, burn it, and there goes (most of) the wealth it represented*. Or, just wait for a market crash... :wink:

* There might still be some value in the land and the burned remains.

If you read again the article I referenced in my first post, you'll see that private banking creates most of the money we use, not the federal government or the Bank of Canada:
Most of the money in the economy is, in fact, created within the private banking system.
Finally, note that we're in Canada. The U.S. Federal Reserve has no jurisdiction, here. The U.S. dollar cannot be used to pay Canadian and provincial taxes; one must use Canadian dollars. Also, Canadian dollars must be accepted by lenders to settle debts.
Last edited by longinvest on 26 Jul 2017 10:58, edited 2 times in total.
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longinvest
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Re: How does fractional reserve banking increases money supply?

Post by longinvest » 26 Jul 2017 00:27

As for actual printed "paper currency", George has already answered your question about it, a few days ago:
Printing or removing currency by Federal Reserve

One should not confuse paper currency with money. They're not the same thing: paper currency is money, but money is not necessarily paper currency. It's often just an entry in a record at the bank.

Only the Bank of Canada can print paper currency (commonly called "cash"). But, this is a very small part of our economy.

Today, most of us have bank accounts where our income is deposited, and we use credit cards (or debit cards) to do most of our transactions; we usually carry very little cash (if any). So, most of our money is just a collection of bits in some computer's memory. Scary, isn't it? :wink:
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Park
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Re: How does fractional reserve banking increases money supply?

Post by Park » 26 Jul 2017 09:01

ghariton wrote:
25 Jul 2017 18:44
About the only "productive debt" incurred by individuals and households is borrowing toward education and other increases in human capital.
http://www.bradford-delong.com/2017/07/ ... ompos.html

Based on the assumptions of their model, the above link finds that the optimal leverage ratio of the US stock market since 1871 has been 2.28.

I'm certainly not advocating the use of leverage by everyone. And even if leverage is appropriate for an investor, few (none?) should have a leverage ratio of 2.28 or anything close to it.

But the responsible use of a modest amount of leverage by individuals and households can be a form of productive debt.

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Re: How does fractional reserve banking increases money supply?

Post by longinvest » 26 Jul 2017 10:10

Park wrote:
26 Jul 2017 09:01
http://www.bradford-delong.com/2017/07/ ... ompos.html

Based on the assumptions of their model, the above link finds that the optimal leverage ratio of the US stock market since 1871 has been 2.28.
The assumptions are so flawed, such as having a 146 years horizon for the money, that it's better to just ignore that article.
Park wrote:
26 Jul 2017 09:01
I'm certainly not advocating the use of leverage by everyone. And even if leverage is appropriate for an investor, few (none?) should have a leverage ratio of 2.28 or anything close to it.

But the responsible use of a modest amount of leverage by individuals and households can be a form of productive debt.
Yes. As George noted earlier, the use of student loans to acquire marketable skills and the use of a mortgage to buy a reasonable house are examples of productive debt, as long as one doesn't overextend the leverage.

For car loans, there are many schools of thought. I personally think that it is OK for younger individuals and households to use a car loan to acquire a reasonable new vehicle. Others think that unless one can pay cash, one shouldn't buy a new car; one should buy a much cheaper used one, instead, then save the money to buy the next one.

Some people believe in leveraged investing. My thoughts about it are mixed; I consider the use of a margin account as gambling (as opposed to investing), because the broker can issue a margin call based on the current market value of securities. Why do I consider this gambling? Because leverage can magnify the losses beyond the value of the investments it was used to acquire and lead a person into bankruptcy, if unlucky.

If the leverage is based on a non-callable, low-interest loan, like a traditional non-callable mortgage or a student loan, then I don't have reservations beyond not overextending the leverage.

Many people use a home equity line of credit (HELOC). Unfortunately, most (or all?) HELOCs are callable, which classify this leverage as gambling, in my view.

If we leave the realm of personal finance and get into the realm of business, then I have no trouble whatsoever with leverage, as long as the borrower is a moral person, such as a corporation. This isolates the gambling part away from the personal finances of the corporation owners. It allows for responsible speculation by limiting the financial liability of owners to whatever they have invested into the corporation in case of a failed venture.

We're getting pretty far from the thread's topic, though.
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Re: How does fractional reserve banking increases money supply?

Post by Rysto » 26 Jul 2017 10:51

vassy wrote:
25 Jul 2017 17:00
Assuming there was just $100 bill in the economy. How is person A going to repay his loan? Where does this extra money gets generated?
You misunderstand the definition of the word "money"in this context. Money, as economists typically define the term, is not synonymous with "currency". Instead economists define money in terms of its function in an economy. Money has three functions:

A Store of Value - You can hold onto money for a while, and still use it to buy something valuable in the future.

A Medium of Exchange - People in the economy will (nearly) always accept money in exchange for goods and services.

A Measure of Value - You can use units of money to determine how valuable something is. If you won't buy a DVD at its list price of $60, then we can say that the DVD isn't worth $60 to you. If you will buy it on sale for $20, then we know it's worth at least $20 to you.

So, fractional reserve banking "creates" money because people treat bank accounts like money as much as they do currency. So in your example, the bank takes a $100 deposit and lends out $90 of it. The $100 bank account plus the $90 in loaned-out money means that the money supply has grown from $100 to $190 (the $10 that the bank holds in reserve cannot be treated as money because legally speaking, the bank cannot spend the money, so it is no longer a medium of exchange)

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Re: car loans

Post by Quebec » 27 Jul 2017 18:51

longinvest wrote:
26 Jul 2017 10:10
For car loans, there are many schools of thought. I personally think that it is OK for younger individuals and households to use a car loan to acquire a reasonable new vehicle. Others think that unless one can pay cash, one shouldn't buy a new car; one should buy a much cheaper used one, instead, then save the money to buy the next one.
Going off topic, but nobody needs a new car, IMO, from a purely financial P.O.V. A five or six years old Corolla with less than 100 000 km on the counter goes from A to B as well as a brand new one. But it costs maybe one third of the new one. You can keep your 5 year old Corolla for another 10 years, bringing depreciation costs to less than $1k per year. Insurance on an older car is also cheaper. Maintenance will be more, but on a Toyota, should be reasonable.

If buying a new car is not needed, then paying interest on this quickly depreciating asset is quite a bad idea indeed. Especially since it shows the young person that they can get a nice looking brand new car, for an ''affordable weekly payment'', and change cars every 5 years. Once in the habit, they will then possibly pay interest on car loans for the rest of their lives. This is money thrown out of the window, pure and simple. Why not get a loan to buy your next fridge or lawnmower then? Where is the limit? For me the limit is clear: never borrow money to buy depreciating assets. If you can't pay cash, you can't afford it.
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longinvest
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Re: car loans

Post by longinvest » 27 Jul 2017 19:51

<off topic>
Quebec wrote:
27 Jul 2017 18:51
Going off topic, but nobody needs a new car, IMO, from a purely financial P.O.V. A five or six years old Corolla with less than 100 000 km on the counter goes from A to B as well as a brand new one. But it costs maybe one third of the new one. You can keep your 5 year old Corolla for another 10 years, bringing depreciation costs to less than $1k per year. Insurance on an older car is also cheaper. Maintenance will be more, but on a Toyota, should be reasonable.
What about consumption smoothing? It's pretty easy for older and richer people to buy new cars cash. Not so much for younger people.

A new car is usually reliable. There are a few exceptions, of course, which lead me to ask myself: Why would someone sell me a five or six years old Corolla in good shape? Wouldn't that person keep it, instead, until it gets less reliable? Isn't that what responsible people do? Do I really want to buy a car from an irresponsible previous owner?

That's what my wife and I do with our cars: we buy them new and keep them until they start requiring repairs. We could possibly have a few more dollars in investments, today, had we not bought new cars, but I'm having a hard time convincing myself that we've crippled ourselves, financially by using debt for our first car; that we would have been better spending some time with mechanics at the garage, when neither of us knows anything about cars nor wants to learn about them.

I've heard, too, that the used car market is not as cheap as it has once been. I don't really know, though.

Actually, I think that we saved a lot in having a single car for the both of us, probably more than having two used cars.
Quebec wrote:
27 Jul 2017 18:51
If buying a new car is not needed, then paying interest on this quickly depreciating asset is quite a bad idea indeed. Especially since it shows the young person that they can get a nice looking brand new car, for an ''affordable weekly payment'', and change cars every 5 years. Once in the habit, they will then possibly pay interest on car loans for the rest of their lives. This is money thrown out of the window, pure and simple. Why not get a loan to buy your next fridge or lawnmower then? Where is the limit? For me the limit is clear: never borrow money to buy depreciating assets. If you can't pay cash, you can't afford it.
There's a difference between buying more than one can afford using car leases, and responsibly buying a new car with debt, keeping the car for a long time.

There are some quite inexpensive new cars on the market, these days. A base-model Micra, without any rebate, costs $13,341 all taxes included in QC (before any negotiation with the car dealer). And it's a Toyota; it should be reliable for a long-enough time.

For the record, our cars were more expensive than the Micra (but, less than double its price, all included). :wink:

</off topic>
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Re: car loans

Post by Quebec » 29 Jul 2017 09:38

Still completely off topic.
longinvest wrote:
27 Jul 2017 19:51
Why would someone sell me a five or six years old Corolla in good shape?
Think of a 60 year old lady (sorry if I'm sounding sexist) exchanging her 5 year old Corolla for a new one. She replaces her car almost as soon as it goes off warranty. While the car is under warranty, she performs all the scheduled maintenance at the dealership. This car is almost as good as new, for a just over a third of the price.

Yes the Micra is tempting, but looks a bit too small with a family of 4. Maybe as a second car, to drive to work.

Fully agree about owning one car instead of two, we're aiming to get back to one car in a few years, although this would involve moving closer to work (I could then walk or bike to work). Owning zero cars would be even better. But very difficult in North America with our very limited public transit, urban sprawl, etc.
There's a difference between buying more than one can afford using car leases, and responsibly buying a new car with debt, keeping the car for a long time.
Sure, but is that what most people actually do? You should see the faces I get at the Toyota dealership when I pay cash for my 5 year old Corollas. Apparently almost everyone borrows money, even for second hand cars.

</off topic>
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Re: How does fractional reserve banking increases money supply?

Post by randomwalker » 30 Jul 2017 18:29

Bill Gross Investment Outlook: Show me the Money, March 2017

"Recently I also explored with them the concept of financial leverage – specifically that of fractional reserve banking, which has been the basis of credit and real economic growth since the system was blessed by central banks over a century ago. “It still mystifies me,” I told them, “how a banking system can create money out of thin air, but it does.” By rough estimates, banks and their shadows have turned $3 trillion of “base” credit into $65 trillion + of “unreserved” credit in the United States alone – Treasuries, munis, bank loans, mortgages and stocks too, although equities are not officially “credit” they are still dependent on the cash flow that supports the system."

https://en-us.janushenderson.com/adviso ... the-money/

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Re: How does fractional reserve banking increases money supply?

Post by bolt » 16 Nov 2017 22:46


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