What happens when someone pays his debt in a fractional-reserve banking system?
Is only his past debt subtracted from the reserve or also all subsequent debts that was loaned to other people with his initial debt?
For instance, a person A borrows 100$ then it becomes part of the reserve, then a person B can borrows from his deposit 80$, then a person C 64$, given a reserve requirement of 10% for banks.
Tags: debts, fractional reserve banking, fractional reserve banking system, initial debt, person c
I think you have it backwards. When person A borrows $100, it does not become part of the reserve. But I understand your real question.
Say the bank gets a deposit of $100. The reserve requirement says that for each $100 it has in deposits, it can issue X dollars in loans. So a $100 deposit increases its ability to make loans by $X.
Now suppose it has already loaned out all that it is allowed to. If a borrower repays the loan, the bank has less outstanding than it is allowed to, and so can loan that money out again.
Now suppose a depositor wants his money back. Now the bank has less money and so it is not allowed to loan out as much. If it has actually loaned to its limit, it is in trouble and either has to call in some loans or get some new deposits ASAP.
To avoid this, the banks pay attention to how much money they expect depositors to withdraw each day and make sure they have enough to cover it. At the same time, they don’t want their money just sitting around doing nothing and earning no interest.
That’s why the banks always have some of their money out on "overnight loans". This is money they know they can get back the next day.
http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6V7T-4HYMSJY-1&_user=10&_rdoc=1&_fmt=&_orig=search&_sort=d&view=c&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=22487fbd87f0f15b9f9be1abdba42d2b
http://ideas.repec.org/p/fip/fedgfe/2004-29.html
One of the problems with the current financial crisis is that banks no longer trust other banks to be able to pay back these short term loans promptly, which has raised the interest rates on these loans:
http://www.washingtonpost.com/wp-dyn/content/article/2008/09/30/AR2008093002629.html