In our current financial system, commercial banks do not keep 100 percent of their depositors’ money in the vault but instead engage in fractional reserve banking.
For example, if a man deposits $1,000 of cash into his bank checking account, the bank updates his balance so that now the man thinks he has that much “in the bank.” The man walks around town, armed with his checkbook and/or debit card, thinking he can spend up to $1,000 drawn on his checking account.
However, typically the man’s bank will only keep a fraction (say, 10 percent) of that money in the vault. It will take the other $900 and lend it out to somebody else. Perhaps a woman applies for a $900 loan at the same bank. The bank uses $900 of what the first man deposited, in order to grant the woman her requested loan. Now she too thinks she has this money. So in a very real sense, the bank just created $900 in new money in the economy, with the act of granting a new loan while operating in a fractional reserve system.
Because of this operation, commercial banks are one source of monetary inflation in our current system of fractional reserves. Besides diluting the purchasing power of the dollar, when bank inflation enters the economy through the loan market, it pushes interest rates below the free-market level. This leads to the business cycle.
Fractional reserve banking can therefore lead to higher prices and a more volatile economy. For these reasons, we (Lara and Murphy) in our book How Privatized Banking Really Works advocate a return to 100 percent reserve banking, in which banks are not able to inflate the total quantity of money in the economy simply by granting loans.