Some people believe that something in the nature of a fractional reserve banking system creates the need for perpetual growth in the quantity of money. I have, therefore, used transactions in a Fractional Reserve Banking System as my primary example. (For an example of a 100% reserve system see the appendix.)

In spite of the many problems caused by fractional reserve banking, it does not cause a need to perpetually expand the quantity of money in order to pay the interest on money debt—as you will see in this model.

Fractional Reserve Banking

In a fractional reserve banking system a bank can create money simply by increasing its promises to pay money (that's current money) to its deposit account holders. A bank in this system simply adds to its deposit liabilities in order to acquire assets, thereby creating new money.

Technically a bank can create money by purchasing any type of asset. By convention and regulation, however, banks generally purchase notes from their customers. We commonly refer to this purchase of notes as the lending process, which I have referred to before.

Unlike a 100% reserve banking system, a fractional reserve banking system requires that banks keep a reserve of commodity money equal to only a portion—or a fraction—of demand (or checkable) deposit liabilities. This fractional reserve requirement allows banks to create demand deposit account liabilities at will (some say, "Out of thin air."). These demand deposit account liabilities exceed the quantity of commodity money maintained on account (or in reserve)—limited only by the current fractional reserve requirement.