Let us summarize where we are:
Pranav wrote:suppose Tom has 10 gold coins, out which he lends 8 to Dick, out which Dick lends 5 to Harry.
Has the money supply increased?
Neshant wrote:There is no increase in the money supply if there are 10 gold coins in the system at all times.
Pranav wrote:If Dick did not increase the money supply by borrowing 8 coins and lending 5, he will not increase the money supply if he does the same thing n times. n times zero is zero.
paramu wrote:Then how did prices go up?
Pranav wrote:Wages and prices are at a higher equilibrium because the gold coins are circulating more instead of sitting under mattresses.
Pranav wrote:total loans are always less than total deposits. Leverage, if defined as the ratio of loans to deposits, is 0.9x, not 9x.
Our model assumed that the currency was gold coins, loans were zero interest, and borrowers were reliable. These simplifications were necessary in order to isolate the points of controversy. As a Einstein said - make things as simple as possible, but no simpler.
Let us now bring in interest, risk, deposit insurance and fiat currency.Interest:
Even if the bank is giving interest to depositors and charging interest from borrowers, the bank will not be changing the number of gold coins in circulation.
There is a legitimate question about whether there are enough gold coins in the system for all the interest to be paid. We will come to that question. For now we just recognize that money supply has not been affected by the actions of the fractional reserve bank.Deposit Insurance:
Some people have strenuously objected to the concept of deposit insurance. Frankly deposit insurance is not fundamentally different from vehicle insurance. You get a license, follow norms, pay a premium and are protected up to a limit. The same applies to banks.Risk:
Some borrowers will be delinquent, in which case the bank will have to cover the loss out of its profit. In extreme situations the deposit insurance and the Central Bank will come into the picture. As regards the role of the Central Bank in mitigating risk, we have touched on it earlier, and will return to the topic later.Fiat Currency:
Since the bank is not running the printing press, nor is it in the business of mining gold and minting coins, whether we are using paper or gold coins is immaterial as far as the bank's operations are concerned. The backing for the currency does, however, have a major impact on the operations of the Central Bank, as we shall see later.
The next big issue is to take a closer look at the concept of backing for the currency, and how the central bank affects the money supply and mitigates risk. Risk can be at two levels - at the level of an individual bank, and at the national level, from the actions of global speculators.