In a fractional reserve banking system, banks can lend out more money than they hold in cash. For example, with a 10% reserve requirement, they can lend out 9 times as much money as they hold in reserves.

One downside of fractional reserve banking is that it can lead to bank runs, i.e. a situation where most people try to withdraw their money because they believe that the bank is about to go bankrupt. On the other hand, there may be some benefits to allowing banks to lend more than they would be able to if constrained by a 100% reserve ratio.

My question is simple: wouldn't it simply be better to impose a 100% reserve requirement (no fractional reserve banking) but simultaneously increase the money supply so that banks have exactly as much money to lend as before? This would seem to leave banks' ability to lend unaffected while eliminating the risk of bank runs.

Or, if you prefer a less normative framing:

Q: What would be the consequences of simultaneously eliminating fractional reserve banking while increasing the money supply so that the total amount that banks can lend remains unaffected?

While I would welcome well informed speculation on this, I would be particularly interested to learn what effects this policy would have in standard macro models which incorporate a banking system.

  • $\begingroup$ I guess that you are concerned that without any special transition mechanism then it appears that a switch from fractional to full reserve banking would cause a dramatic fall in the money supply. Proposers of full reserve banking plans are all very well aware of this and so all the plans include mechanisms that avoid the problem and keep the money supply level during the transition. $\endgroup$
    – Mick
    Oct 26 at 15:59
  • $\begingroup$ You remove the ability of the free market to create and destroy money. Is that a good idea? You also make the ability of banks to lend be no more dependent on their deposits. You are basically giving a group of investors (former banks) free money to lend out how they see fit... $\endgroup$
    – user253751
    Oct 27 at 16:50

You are actually not the first person to wonder about this, there is a whole literature on this topic (although most of it is now out of date). What you describe is called “the Chicago Plan”. It was originally proposed by several economists from the university of Chicago notably Irving Fisher.

Nonetheless, you might be pleased to learn that there is actually even modern research that tries to examine what effect would this have on economy using some standard macro models and so we do not need to just speculate.

More specifically, in 2012 Benes and Kumhof written IMF working paper (that was later expanded to full book) titled the Chicago plan revisited. In this paper the authors examine the implications of 100% reserve banking using modern DSGE models.

The authors main findings are:

by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher's claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy.

The full model is shown in their paper linked above. You can also find more details in their book with the same name.

However, note the paper is not without its critics, so you should not necessarily take the results in the paper at face value. You can see overview of those in this old SE answer. Ultimately, without having an empirical evidence by having some country trying this out it is very difficult to say how much you can trust the DSGE models used to examine the idea.

  • $\begingroup$ Thanks for the reference. Do you know if an important part of the plan was to expand the monetary supply (so banks have as much money to lend as before)? $\endgroup$
    – afreelunch
    Oct 26 at 15:52
  • $\begingroup$ @afreelunch yes they start with the same money supply but of course because economy is an endogenous system the money supply in this economy would not be the same in counterfactual with frac reserve banking after some time since this affects real output as well (the authors show increase of 10%) and also thus affects central bank actions going forward. For example, by Taylor rule if there is some positive shock to Y you want to pursue more contractionary monetary policy. But both scenarios start with the same parameters they just of course have to change over time since system is different $\endgroup$
    – 1muflon1
    Oct 26 at 16:23

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.