On the social usefulness of fractional reserve banking

V. V. Chari; Christopher Phelan

doi:10.1016/j.jmoneco.2014.04.008

On the social usefulness of fractional reserve banking

Economics (Twin Cities)

Research output: Contribution to journal › Article › peer-review

15 Scopus citations

Abstract

In this paper we argue that if monetary policy has insufficient deflation, private agents have incentives to set up alternative payment systems like fractionally backed bank deposits, which pay interest on the means of payment. In a competitive environment with free entry, these alternative systems are inherently fragile in the sense that they are subject to socially costly bank runs. These social costs are not internalized by private individuals and banks and may exceed their social benefits. We argue that as communication technologies improve, the social benefits of fractional reserve banking decrease, but the private benefits may still exceed the private costs so that such systems continue to be used. In such situations, 100% reserve requirements are optimal.

Original language	English (US)
Pages (from-to)	1-13
Number of pages	13
Journal	Journal of Monetary Economics
Volume	65
DOIs	https://doi.org/10.1016/j.jmoneco.2014.04.008
State	Published - Jul 2014

Bibliographical note

Funding Information:
This paper was presented at the November 2013 Carnegie-Rochester-NYU Conference on Public Policy. We thank Marvin Goodfriend, Ed Nosal, and an anonymous referee for useful comments. Chari thanks the National Science Foundation for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

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Keywords

Bank runs
Cash in advance models
Friedman rule
Pecuniary externalities

Publisher link

10.1016/j.jmoneco.2014.04.008

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title = "On the social usefulness of fractional reserve banking",

abstract = "In this paper we argue that if monetary policy has insufficient deflation, private agents have incentives to set up alternative payment systems like fractionally backed bank deposits, which pay interest on the means of payment. In a competitive environment with free entry, these alternative systems are inherently fragile in the sense that they are subject to socially costly bank runs. These social costs are not internalized by private individuals and banks and may exceed their social benefits. We argue that as communication technologies improve, the social benefits of fractional reserve banking decrease, but the private benefits may still exceed the private costs so that such systems continue to be used. In such situations, 100\% reserve requirements are optimal.",

keywords = "Bank runs, Cash in advance models, Friedman rule, Pecuniary externalities",

author = "Chari, \{V. V.\} and Christopher Phelan",

note = "Funding Information: This paper was presented at the November 2013 Carnegie-Rochester-NYU Conference on Public Policy. We thank Marvin Goodfriend, Ed Nosal, and an anonymous referee for useful comments. Chari thanks the National Science Foundation for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.",

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AU - Chari, V. V.

AU - Phelan, Christopher

N1 - Funding Information: This paper was presented at the November 2013 Carnegie-Rochester-NYU Conference on Public Policy. We thank Marvin Goodfriend, Ed Nosal, and an anonymous referee for useful comments. Chari thanks the National Science Foundation for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

PY - 2014/7

Y1 - 2014/7

N2 - In this paper we argue that if monetary policy has insufficient deflation, private agents have incentives to set up alternative payment systems like fractionally backed bank deposits, which pay interest on the means of payment. In a competitive environment with free entry, these alternative systems are inherently fragile in the sense that they are subject to socially costly bank runs. These social costs are not internalized by private individuals and banks and may exceed their social benefits. We argue that as communication technologies improve, the social benefits of fractional reserve banking decrease, but the private benefits may still exceed the private costs so that such systems continue to be used. In such situations, 100% reserve requirements are optimal.

AB - In this paper we argue that if monetary policy has insufficient deflation, private agents have incentives to set up alternative payment systems like fractionally backed bank deposits, which pay interest on the means of payment. In a competitive environment with free entry, these alternative systems are inherently fragile in the sense that they are subject to socially costly bank runs. These social costs are not internalized by private individuals and banks and may exceed their social benefits. We argue that as communication technologies improve, the social benefits of fractional reserve banking decrease, but the private benefits may still exceed the private costs so that such systems continue to be used. In such situations, 100% reserve requirements are optimal.

KW - Bank runs

KW - Cash in advance models

KW - Friedman rule

KW - Pecuniary externalities

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DO - 10.1016/j.jmoneco.2014.04.008

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VL - 65

SP - 1

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JO - Journal of Monetary Economics

JF - Journal of Monetary Economics

ER -

On the social usefulness of fractional reserve banking

Abstract

Bibliographical note

UN SDGs

Keywords

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