Pros And Cons Of The Fractional Reserve Banking System

Question 4: The fractional reserve banking system is prone to financial instability. Economic events such as the 1930’s Great Depression and 2008’s Global Financial Crisis are the proven phenomenon stemming from the fractional reserve banking system. Van Dixhoorn (2013) states that banks are exposed to the risk of bank runs, where many depositors lose confidence in the security of their bank, leading them all to withdraw their funds at once. Banks have experienced this during the Great Depression (GD) in the 1930’s. To counter this issue, deposit insurance schemes have been established to aid the stability of the payments system, along with the safety of savings and credit. However, these guarantees alter risk relations, this led to an introduction

When faced with a recession, banks tend to lend less as the amount of credit and money shrinks. The central bank has limited control over money and credit, and in order to stimulate economic growth, the government must increase the level of debt to increase the money supply during an economic downturn (Van Dixhoorn, 2013). Backed by, Douglas et al. (1939) they stated that the fractional reserve banking system gives commercial banks power to increase or decrease the volume of an economy’s circulating medium by decreasing or increasing investments and its bank loans. As each bank practices this power without centralized control, the changes in the level of circulating medium are largely arbitrary. This condition is a very important factor in an economic boom and depression. In booms, many are keen to borrow; in depressions, lenders are reluctant to lend but eager to collect. It is due to these factors of over-lending and over-liquidating that tends to heighten the economic conditions of both booms and depressions, it is the relation between the capacity of the circulating medium and the capacity of bank loans which is

An example of a proposal for monetary reform used here is the Chicago Plan; summarized by Irving Fisher of Yale University, Fisher (1936) claimed four major advantages for this plan. First, averting banks from creating their own funds during credit booms, then eliminating these funds during subsequent contractions. This allows steadier control of credit cycles, which is apparent to be the key factor of business cycle fluctuations. The second advantage is full reserve banking would thoroughly eliminate bank runs; when all deposits are fully backed by reserves, depositors can sleep easy as the full amount of their deposits are fully accessible (Van Dixhoorn 2013). Third, permitting governments to directly issue money with no interest, instead of borrowing that same money from banks at interest, resulting to a decrease in interest burden on government finances leading to a reduction of government debt. Fourth, a reduction of private debt levels, as money creation would not require the synchronized creation of private debts on the balance sheet of banks, an economy could see a major decrease of not only government debt, but also levels of private debt (Benes & Kumhof