The Free Market Center
The Free Market Center
To test the hypothetical need for a perpetual increase in the quantity of money let's first look at the process of money lending from four different perspectives—combinations of two different outcomes for the borrower and two different banking systems.
The following table provides a matrix of those combinations:
| 100% Reserve Banking | Fractional Reserve Banking | |
|---|---|---|
| Borrower Succeeds & Repays Loan | Model #1 | Model #3 |
| Borrower Fails & Defaults on Loan | Model #2 | Model #4 |
Although these models depict two different outcomes in two different banking environments, I have, in order to make them easier to comprehend, kept the basic parameters of these models similar. On the next three sections below I will briefly:
The Actors
To make these models easily understood I have used in all models the same three economic actors engaged in transactions that involve the transfer of goods and the borrowing of money. The three actors are a corn grower, a seed dealer, and a bank.
The grower owns land on which he grows corn, but he has no seed for this year’s planting, and he has no money with which to buy seed.
The seed dealer makes a business out of buying and selling seeds to and from farmers, such as our corn grower. In this model the dealer will sell corn seed to the grower, then, after the growing season, he will buy seed from the grower.
The final actor, the bank, lends money to the grower for the purpose of buying seed. In return for a loan of current money, he accepts from the grower a note for an amount of future money—a loan. The difference between the amount of current money that the bank gives to the grower and the quantity of future money which the grower returns to the bank at the end of the growing season consists of interest.
To make the models simple I have used a single bank to represent the entire banking system. That bank holds all money; therefore, the bank's deposit liabilities equal the money supply.
Banking Systems
I have used two different banking systems to demonstrate the influence, if any, the type of banking system has on whether the system requires more money for interest payments.
The banking system in the first model requires 100% reserves. The bank must retain commodity money equaling hundred percent of its demand deposit liabilities. (For simplicity, I have assumed no time deposits.)
In this type of banking system the only way new money can be created is through the production of more commodity money, which does not occur in this model. Also, because of the hundred percent reserve requirement, and because the bank has no time deposits, the bank will have to make loans from its own money.
The banking system in the second two models uses a fractional reserve banking system. 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 holders.
In this type of system a bank adds to its deposit liabilities in order to acquire assets. Technically a bank can create money by purchasing any 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.
Transactions
In these four models I have used the same basic pattern of four transactions within two outcomes. In the first outcome, the grower has a successful crop and repays his loan. In the second outcome, the grower has an unsuccessful crop and he fails to repay his loan. The differences in these outcomes affect only the last two transactions.
Those outcomes and transactions, from the grower’s perspective, consist of:
With a basic outline of the actors, the banking system, and the transactions,…