202-T&C-9 - Econ 202 Terms and Concepts 9 FRACTIONAL...

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Econ 202: Terms and Concepts 9: FRACTIONAL RESERVE BANKING Fractional Reserve Banking Fractional Reserve Banking is a system of banking wherein the banker retains as a cash reserve a proportion of depositors’ money and loans out the rest in order to make collective savings available to investors and allow depositors to participate in the profitability of the investment. This system of banking was introduced in the 15 th century and is responsible for the commercial and industrial development of our modern economies. Capitalization on the scale of the industrial revolution is not possible unless the savings of many people can be collectivized. There are obvious safeguards needed: Unloaned reserves must be adequate so that routine withdrawal demands of depositors can be met; usually done by regulation Standardized accounting system must exist to keep track of share ownership Risk preferences of the banker must be regulated or at least revealed to depositors The catch in a fractional reserve system is that depositors must have confidence that their money can be withdrawn on demand. If that confidence exists, then only routine, predictable withdrawals will be demanded. However, if depositors lost confidence and all try to withdraw all of their money at the same time, the banking system will collapse because long-term loans cannot be recalled on demand. Role of Money The most important and most widespread use of money is as a medium of exchange . Exchanges are more efficient in a monetized economy than they are in a barter economy because there is a common denominator of exchange. The demand for money to finance exchanges is called transactions demand , and, as we have seen, this goes up and down over the course of the business cycle, as the volume of exchanges increases during upturns and declines during downturns. Money also serves as a store of value , a form in which prior surpluses can be saved without deteriorating. The demand for money – cash - as a form in which savings might be held is called the asset demand for money. The most important asset demand for money comes from the banks; this is their liquidity preference that we discussed in the last T&C. Within the banking system, asset demand and transactions demand are complementary to one another.. When the liquidity preference of banks is low (as it usually is during an upturn), they loan out the money and the liquidity circulates in the economy, financing the high transactions demand. When liquidity preference is high (as it usually is during a downturn), banks do not loan out the money and the liquidity stays in the bank, representing a preference for cash assets rather than long terms assets such as loans or bonds. Transactions demand is correspondingly low. The equilibrium between liquidity (holding on to cash) and capacity (investing in long term capital) is delicate, and discretionary monetary policy is really all about tweaking this equilibrium while avoiding inflation.
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