From the Gold Standard to the Fractional Reserve System

Fractional History

Since the end of gold’s dominance, the world economy has largely operated under the Fractional Reserve system.

Savers of money were in search of safekeeping depositories for their valuables, including gold and silver coins, eventually lending these to goldsmiths who would return a receipt (an IOU or note) for their deposits. Gaining the trust of people, these goldsmiths’ notes became a popular medium of exchange and an early form of paper money was created.

But during this process, goldsmiths began to notice another trend.

During trades, people would not usually redeem all their notes at once and so the goldsmiths took this opportunity to re-invest their gold coin reserves in interest-bearing loans and bills. Clearly, income was generated for the goldsmiths leaving them with more issued receipts than gold reserves. The goldsmiths’ role as a guardian of gold and charging fees for secure storage was altered to that of an interest-paying and interest-earning bank.

And that’s how the Fractional Reserve system was born.

Midas’ Tip Sheet

The gold standard was used to regulate the quantity and growth rate of a country’s money supply. It ensured that, for most countries, the money supply (and thus the inflation rate) was relatively stable as new production of gold added only a small amount to the accumulated stock. An exception to this was when Australia and California discovered many gold reserves in the early 1850’s, causing global price levels to shortly become very volatile.

The gold standard was an example of a fixed exchange rate regime where most currencies were convertible directly into gold at fixed rates, so exchange rates between countries were also fixed. Canadian dollar bills, for example, could be exchanged for approximately 1/20 ounce of gold. Likewise, the British Treasury would exchange 1/4 ounce of gold for one pound.

Because a Canadian could convert twenty dollars into one ounce of gold, which could be used to buy four pounds, the exchange rate between the pound and the Canadian dollar was effectively fixed at approximately five dollars to the pound.

As exchange rates were fixed, the gold standard was the cause of parallel movements in the price levels around the world. This movement mainly occurred through an automatic balance-of-payments adjustment process known as the “price-specie-flow mechanism.”

To explain, this mechanism operated like so: using the US as an example, if a technological innovation was the result of quicker real economic growth in the United States and the supply of gold in the short run was fixed, the U.S. price level would fall. Therefore, U.S. exports were less expensive relative to their competing imports (say, from the UK); as such, the British would demand more exports while the Americans would demand less imports.

The result?

The U.S. balance-of-payments system is at a surplus causing gold (specie) to flow from the United Kingdom to the United States. The inflow of gold increased the U.S. money supply having the reverse effect of increasing prices while the outflow of gold reduced the U.K. money supply, lowering prices. The net effect was balanced prices among the two countries.

The drawback of the gold standard is that it was known to cause both monetary and non-monetary (real) shocks. These were transmitted through flows of gold and capital between countries. A monetary shock in one country would affect the money supply, domestic expenditure, nominal income, real income, and the price level in another country. An example of a monetary shock was the California gold discovery in 1848.

If the gold standard was to function effectively, the Central Bank had to play by the “rules of the game.” Michael D. Bordo, a professor of economics at Rutgers University explains that these banks were supposed to “raise their discount rates (the interest rate at which the central bank lends money to member banks) to speed a gold inflow, and to lower their discount rates to facilitate a gold outflow. Thus, if a country was running a balance-of-payments deficit, the rules of the game required it to allow a gold outflow until the ratio of its price level to that of its principal trading partners was restored to the par exchange rate.”

The Fractional Guide

As for the Fractional Reserve system, this is where commercial banks (not the government) are ultimately involved in the creation of money. To initiate the process, people deposit their money in banks, who then lend out a fraction of their depositors money to other customers. The remaining funds are held with the banks as reserves.

These customers pay interest on the borrowed funds used to finance the banks’ expenses of conducting business (that is, to pay interest to their depositors) and as a source of profits for the banks’ owners. The bank behaves as an intermediary between the people who have a surplus of resources and those who have a lack of it. When lending out money, the bank absorbs most of the risk and must return the principal to the depositor irrespective of their return on the investment.

The practice of Fractional Reserve banking has a cumulative effect on the banking system, allowing it to create money. For instance, if Jason deposits $100 in Bank A, which lends out $50 to Ray who spends it, the money is eventually deposited in Bank B by a different person. Bank B then lends out $25 to Mary, which is spent and deposited in Bank C. The process continues indefinitely until the total amount of deposits equals a multiple of the initial amount of cash deposited in Bank A.

In this example, the total amount of deposits, $200, is exactly twice the initial amount of cash, $100. This multiple is known as the money multiplier, which depends on the required reserve ratio and the currency ratio.