Background

This is a simple implementation of the Textbook Fractional Reserve Banking System currently (circa August 2011) found in entry level Economic Textbooks (for example Mankiw, Principles of Economics), with loan repayment included. The model uses a simple interest calculation for loan repayments, does not have a central bank, and is purely intended to allow exploration of the behaviour of the textbook description, under somewhat more realistic conditions than presented in the textbook.

IMPORTANT:

This simulation is not intended to be, nor is it, a realistic simulation of any actual reserve based banking system. Nor was the original description, which the textbooks have copied and pasted, but somehow it became one. Unfortunately, because the textbook version is so inadequate, almost everything currently written about fractional reserve banking systems is at best misleading.

The textbook description appears to originate from the 1931 MacMillan Report to the British Parliament, which was mostly authored by Keynes. The relevant text can be found here:

http://tinyurl.com/3vsnmnb

The context suggests Keynes probably didn’t intend this to end up being any kind of definitive description, he was just trying to explain the deposit - loan - redeposit process. It’s worth noting that this appears to be the first coherent description that was published, and also that bank deposit expansion itself within the banking system was only really recognised by the end of the 1890’s. See the paper below for a fuller background:

http://ntu.ac.uk/nbs/document_uploads/109025.pdf

The following problems can be identified with the textbook description:

  • It does not include loan repayments
  • It does not describe how loan defaults are handled.
  • It predicts an asymptotic stability that has never been supported by empirical data from any known banking system.
  • It is not an accurate description of any banking system that has ever existed.
    • Modern systems are based on a variety of equity capital regulations and in many countries have removed reserve requirements
    • Gold standard based systems similarly used a variety of regulatory frameworks and typically regulated physical notes and coins to the price of gold, rather than the quantity of bank deposits as implied by the textbook model.

The intended purpose of this simulation is to provide a very simplified, but realistic in systemic terms, implementation of lending, loan flows and deposit creation within a factional reserve based banking system, useful as a basis for exploring the behavior of different regulatory frameworks. It is highly probable, given the inherent recursive feedback nature of the banking system, that the dynamic behaviors shown by the simulation are also present in current and past banking systems, but full scientific simulation of the complete regulatory framework is required before that claim can be substantiated.

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