Chapter 2

The Fundamentals of Fractional-Reserve Banking

Over the 50 years up to the onset of the recent financial crisis, industrial production in the United States increased by a factor of roughly five.1 Over the same period the amount of dollar notes and coins in circulation increased by a factor of 26.2 The Federal Reserve's wider aggregate of money, M2, which in addition to the currency in circulation includes various forms of bank deposits that can be used fairly easily for transactions, increased by a factor of 25.3 That this money was not needed, we can state with complete certainty. Neither was it created in response to any autonomous demand for cash by the general public. Indeed, the demand for money did not rise anywhere near as much over this period as the supply of money did. The public could be persuaded to hold these massively inflated quantities of media of exchange only by severely diminishing the purchasing power of every single dollar. Over this period every dollar lost about 86 percent of its purchasing power if measured on the basis of consumer prices. In 2007 $1 bought about 14 percent of what it bought in the late 1950s.4

Why was all this money produced? The short answer is, because the money producers could do so and deemed it appropriate. This may at first appear to be a facetious answer. But if the supply of paper money is not regulated by the independent demand from money users, as we have just concluded, then it must be purely the result of the activities ...

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