Financial Stability and Fractional Reserve Banking

Shengxing Zhang, Cyril Monet and Stephan Imhof ()

No 1407, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: We analyze the optimal risk-return trade-off when banks can issue inside money. Optimally the quantity of inside money is restricted by some reserve requirements. Increasing the reserve requirements or decreasing the rate of return on central bank money makes loans to the private sector more expensive. This induces borrowers to take more risk. However, leverage also decline, which induces borrowers to take safer decision. The optimal combination of reserve requirement and inflation trades-off both effects. The Friedman rule or zero reserve requirement is not necessarily optimal, as it would induce too much leverage. In spite of being the safest system, fully backed inside money is not optimal as it reduces leverage too much.

Date: 2017
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed017:1407

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