On the social usefulness of fractional reserve banking |
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| Institution: | 1. Columbia University, Department of Economics, International Affairs Building, 420 West 118th St., New York, NY 10027, United States;2. NBER, United States;1. Harvard University, USA;2. Bank of International Settlements, Switzerland;3. INSEAD, France;1. London Business School, Regent?s Park, London NW1 4SA, United Kingdom;2. Department of Economics, University of Leicester, Leicester LE1 7RH, United Kingdom;1. Paris School of Economics, France;2. École des Hautes Études en Sciences Sociales, France;3. European Business School, France;4. Rutgers University, United States;5. NBER, United States |
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| 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. |
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| Keywords: | Friedman rule Bank runs Cash in advance models Pecuniary externalities |
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