Should Banks Create Money?

The paper compares the welfare properties of the current fractional reserve banking (FB) system versus a narrow banking (NB) system where inside money is fully backed by reserves issued by the central bank. The analysis shows that under sufficient competition FB is beneficial compared to NB because of higher interest payments on inside money. Since under FB inside money funds loans, banks have higher income on their asset side which they pass on to inside money holders in the form of higher interest if competition is sufficiently high. This improves welfare because it compensates the inside money holders against inflation. A calibrated version of the model suggests however that the welfare gains of FB are relatively small, below 0.15% of GDP p.a. in the US between 1984 and 2008