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For example the black death occurred in basically a full reserve system. Because there was no m2 to destroy, the fall in output was inflationary. The same money existed chasing fewer goods.

Doesnt the same paradigm apply to fractional reserve? If the monetary base is around 10% of the supply then wouldn't a 90% collapse in output eventually become inflationary?

Money velocity is one way deflation could still happen. But even then arent there also fairly high floors to velocity, for example rental yields tend to increase in recessions therefore this would raise velocity anyway?

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    $\begingroup$ I would worry more about a 90% collapse in output than inflation. $\endgroup$ – Michael Greinecker Jun 23 '20 at 7:46
  • $\begingroup$ I am just asking that since output collapse is normally deflationary does the relation reverse after m2 is totally destroyed? $\endgroup$ – D J Sims Jun 23 '20 at 8:12
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    $\begingroup$ The Black Death saw a collapse in both supply and demand, but more significantly a major change in the capital/labour ratio. This was not primarily a monetary shock but one which drove up wages relative to rents, followed by an attempt by landowners to prevent the market-clearing operation of the labour market. $\endgroup$ – Henry Jun 23 '20 at 11:11
  • $\begingroup$ Arent they more or less identical processes, if money (a capital) is abundant doesnt that push landowners to raise rents as well? $\endgroup$ – D J Sims Jun 23 '20 at 11:37
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    $\begingroup$ Based on online comments by medieval scholars, a lot of discussions about the Black Death are largely fictional, so it’s not a good reference point. People base comments on old research that was invalidated decades ago. $\endgroup$ – Brian Romanchuk Jun 23 '20 at 11:46
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Without a historical reference, I have doubts about the Black Death reference. Scholarship around the Black Death has changed.

The premise behind this question is that the velocity of money is constant. Since we can see that it is not - link to FRED M2 velocity - we need to ask what else drives the price level.

The obvious concern is that there is no explanation of how output falls 90%. Is it because of out-of-control bankruptcies causing business failures, while the government does nothing? That’s a deflationary environment. Was there a war or pandemic that destroyed industrial capacity? Probably inflationary.

If we step away from the text of the question, and just look at the title - does fractional reserve banking limit the shrinkage of the money supply - the answer is technically no. For the few remaining countries with reserve requirements, if deposits fall, so do required reserves. If the central bank keeps excess reserves at zero, then reserves will shrink along with deposits. As for currency in circulation, it is determined by the desire of the private sector to hold it. If holdings depend on incomes, holdings will fall in line with incomes.

What might keep the monetary base from shrinking is a deliberate policy choice of the central bank.

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  • $\begingroup$ Velocity of money also has a floor so it would still be inflationary. If output keeps going down then wealth effects will eventually raise consumption and stop velocity from falling $\endgroup$ – D J Sims Jun 23 '20 at 18:18

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