The Monetary System: Fractional Reserve

a-How money is created:

1- Central Bank prints money and buys Safe securities: Government debt or corporate debt.
2- Recipient of money deposits money in bank, which can now be lent via fractional reserve.
3- Money is created via lending.

Base Money (M0): Money created by the FED when they purchased asset.
M1: All the currency in pockets+ Check Writting
M1: M0 +checkable deposits- Bank Reserves
M2: M1+ Things easy to convert to M1 (Savings account+Money market mutual acc.)

Typically money refers to M1, which is money that is readily usable to facilitate transactions.

c-Problems with Fractional Reserve

- Reserve requirements place limits to bank lending. (10% in the U.S.)

1- Fundamentally unstable- If there is a crisis at one bank or rumours, everyone shows up to

demand deposits but not enough reserves. Solution is FDIC
2- Bad incentives- FDIC, no incentives for the market to scrutinize banks lending practices.
3- Money creation- Recession, less money less lending, boom, more lending more money.

You must have central bank to mantain system:

– Central bank deposit insurance
– Central bank lender of last resource

Significant part of money creation in hand of private banks, not central banks.

d- Full Server Banking

– A part is on demand, and the rest is timed deposit (1-3 years). Then the money is lent out,
banke engages in maturity lending.
– Banks must charge fees on “on demand” money to customers for safeguarding money.
– This is how banking was until the mid XIV century.
– Venician bankers started fractional reserve lending.
– Mainstream banks full reserve until 1800s.
– Great depression, economists proposed going back to full reserve banking: A program for
monetary reform. (1939) Most economists supported it at the time.

e-Money and Interest Rate

Interest rate: Price of money, rent on money.