Fractional Reserve Banking and Inflation

In a comment to a previous post, the question of why there is inflation arose. Being a complete neophyte in economics, I began to think about this question. Along the way, I discovered some very interesting things about how the monetary system works. I'm not sure if I can answer the question correctly but here is my unqualified answer.

The main mechanism behind inflation seems to be what is known as fractional reserve banking. Here by mechanism, I don't mean what economic factors drive inflation, but simply how does extra money get into the economy. When you get a bank loan, they don't dig into their vault and give you the money. Instead, they simply put those dollars into your bank account. The money is basically created out of thin air. All the bank is required to do is to make sure that they have enough reserves to cover some fraction of their loans. It's a complicated formula but it amounts to something like ten to fifteen percent. Each night, the banks must balance their books and they partially do this by borrowing money from the US Federal Reserve which lends at the Fed rate. In that way the Fed can influence the money supply in the economy. The amazing thing about this system is that in principle the money supply could be any size. When money is lent to you and you buy something from someone else, they can deposit that money back into the bank which can then be lent out again while only keeping ten percent in reserve.

So, when interest rates are low, the money supply expands and we get inflation or a bubble. When interest rates increase, the money supply can shrink and then we can have a slowdown in the economy, a recession or a bursting of a bubble (as we are experiencing now in real estate). If the money supply was completely static then if the economy grew we would experience deflation. (This is happening in some sectors like electronics and food where the cost of production is decreasing faster than inflation.) The problem with deflation is that people then tend to wait before they buy things and that can retard economic growth. So, the Fed tries to engineer a small amount of inflation to keep things going. When the economy is too heated then it raises the rate slightly to keep it in check, which is what the Fed has done for the past two years.

I think one of the reasons why inflation has been relatively benign these past few years even with low interest rates is that the extra cash has been used to fuel the internet bubble followed by the real estate bubble and also our savings rate is so low that banks don't have enough reserve to further inflate the money supply. However, just to make sure I end on a gloomy note, Nouriel Roubini is predicting a recession in 2007 triggered by the bursting of the housing bubble. So interest rates may actually be coming down again.