Less money?

What if money creation is limited?

In article no. 4, I wrote:

So if fractional reserve banking were forbidden, and money creation through credit granting were no longer possible, the result would be money tightness and much higher interest rates. In spite of granting far fewer credits, banks would probably still earn about as much interest as before, because of the higher rates.

That was in July this year, and it is now October. I now look at this matter a little differently.

No more credit

One point is that money creation is not caused by fractional reserve banking, but by credit granting per se. So to forbid and avoid all money creation (by non-central banks), any credit granting should be forbidden. I cannot imagine that anyone would seriously recommend that, because it would have a considerable negative impact on the functioning of the economy.

Full reserve banking

What is possible though, is to change the funding of loans. In the existing system, both short and long deposits may be used to fund loans. We could restrict that to just long deposits. That would make banking safer than it is now.

In the existing system, bank runs are possible but unlikely. In a possibly implementable full reserve banking system, bank runs would not only be unlikely, but even impossible.

But this would have important repercussions, one of which I described in article no. 7.


Less funding for loans means less money creation. In article 4 I assumed that would drive up the interest rates. But now, in hindsight, I expect the central bank would instead take measures even before that can happen.

In Modern Money Mechanics, on page 3 we can read:

How much money is demanded depends on several factors, such as the total volume of transactions in the economy at any given time, the payments habits of the society, the amount of money that individuals and businesses want to keep on hand to take care of unexpected transactions, and the foregone earnings of holding financial assets in the form of money rather than some other asset.

Control of the quantity of money is essential if its value is to be kept stable. Money’s real value can be measured only in terms of what it will buy. Therefore, its value varies inversely with the general level of prices. [...]

More base money

One of the basic tasks of any central bank is to keep prices stable. If there isn’t enough money, deflation is likely to occur and prices will tend to go down. Just like too much money causes higher prices and inflation.

That means in a full reserve system, where less money creation takes place by non-central banks than with fractional reserve banking, the central bank would probably compensate for this, by providing more base money.

The net effect would be, that there is just as much money in circulation as in a fractional reserve system, interest rate levels would be the same, and so would the earnings by non-central banks, derived from debit interest.

Copyright © 2012 R. Harmsen. All rights reserved.