Full Reserve Banking - GS Paper 3 - Economy

Full Reserve Banking – GS Paper 3 – Economy

Full Reserve Banking 

A banking system known as full-reserve banking, also known as 100% reserve banking, prohibits banks from lending out funds that they receive from clients in the form of demand deposits. 


Under full-reserve banking, banks are required to keep all of the funds they receive from consumers as demand deposits in their vaults at all times. In this situation, banks only operate as custodians over depositors’ funds and may charge depositors a fee in exchange for the service of providing safekeeping.


In a full-reserve banking system, banks are only permitted to lend funds that their clients deposit as time deposits. Time deposits are sums of money that consumers can only withdraw from a bank after a predetermined amount of time that has been set by the bank and its clients. 


With the help of this arrangement, banks are given time to lend these deposits to borrowers at a specific interest rate, collect payments from the borrowers, and then finally return the depositors’ money plus a specific amount of interest.


But, in a full-reserve banking system, banks are not allowed to make loans unless there is actual cash in their safes to back these loans.


Fractional -Reserve Banking

Banks rarely lend money in the form of physical currency in the current banking system, often known as the fractional-reserve banking system. So, the cash deposits they receive from their clients—whether they are time deposits or demand deposits—remain largely in their vaults.


When a bank wants to lend money, it need only create a loan account in its records in the borrower’s name and credit it with electronic funds equal to the loan amount. In reality, the value of these digital loans that banks produce out of thin air may end up being many times greater than the actual quantity of money that is kept in the banks’ vaults. 

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So, the bank might be obliged to spend all the cash deposits it got from depositors to meet the demand for cash and still be unable to meet that demand if borrowers opted to take in cash all of the money that was loaned to them electronically by the bank.


Need for Full-Reserve Banking

Proponents contend that it is the only organic form of banking and that it is capable of avoiding the multiple crises that currently plague the fractional-reserve banking system. The likelihood of a bank run would be minimal under a full-reserve banking system because banks would be legally required to hold demand deposits in their vaults to meet depositor demands for cash and because they would only be permitted to make loans to borrowers out of their time deposits.


Additionally, proponents of full-reserve banking contend that banks’ ability to affect the level of the money supply in the economy will be severely constrained because they won’t be able to print money under a full-reserve banking system. They contend that by doing this, artificial economic booms and busts—which are allegedly caused by variations in the money supply—will be avoided.

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