American Journal of Economics and Business Administration

Original Research Paper

Fractional Reserve Banking and Price Stability: Evidence

from Gulf Cooperation Council (GCC) Countries
1
Osman Sayid Hassan Musse, 2Abdelghani Echchabi and 3Hassanuddeen Abdul Aziz
1
Faculty of Economics and Muamalat, Islamic Science University of Malaysia,
Bandar Baru Nilai, 71800 Nilai, Negeri Sembilan, Malaysyia
2,3
College of Business, Effat University, Jeddah 22332, Saudi Arabia

Article history Abstract: This study aims at investigating the possible influence of the
Received: 16-7-2015 current money creation process applied by the commercial banks through
Revised: 25-7-2015 the fractional reserve system on the overall prices stability in the Gulf
Accepted: 6-8-2015 Cooperation Council (GCC) countries. The study uses yearly data spanning
from 2008 through 2013 for Qatar, Kuwait, Oman, Saudi Arabia and
Corresponding Author: United Arab Emirates and applies panel regression analysis based on the
Abdelghani Echchabi pooled data set. The results indicate that neither outstanding deposits nor
College of Business, Effat
University, Jeddah 22332,
outstanding loans have a significant influence on general price levels.
Saudi Arabia
Email: [Link]@[Link] Keywords: Debt Creation, Fractional Reserve, Inflation, GCC

Introduction assistance of fractional reserve mechanism. This process

is called debt creation in the form of bank loans.
Under both monetary systems-commodity backed For instance, in the case United Kingdom, private
money and paper money, the primary objective of banks create 97% of the money in circulation in the form
monetary policy is to maintain price stability for goods of loans, while the bank of England issues only 3% of
and services and to have a stable value for money in all the money, which is in the form of banknotes. This is
economic periods. This is to protect the savings and particularly true in a society, where the access of
avoid exchange rate volatility and the un-stability in credit/debit cards, internet banking and mobile banking
general price level and most importantly to retain public is high. This newly created money is only existing in the
confidence in local currencies. form of electronic/digital/accounting entries in banks’
In this regard, there are a number of tools to uphold computes, but, it does not exist in the form of cash
the value of the money as a stable currency and to tackle (Ryan-Collins et al., 2014).
the increasing inflation rate. Quantity control is one of As a result, this newly created money increases
the successful policies to control money quantity. As a money growth rate and subsequently reduces the
consequence, any change in the quantity of money will purchasing power of the currency and leads to high
lead either to inflation or deflation in the economy. The inflation as well as wealth transfer form the largest group
increase in the quantity of money often will be due to of the society to the smallest group (Meera, 2004).
printing additional banknotes by central banks or issuing Besides that, Stoop and Sornette (2010) concluded
loans by commercial banks through fractional reserve that credit creation fuels economic bubbles, making the
system (Federal Reserve Bank of Chicago, 1994). In system unstable and leading economies into crises. This
other words, one of the advantages of price stability is is in the line with general belief about the monetary
that it encourages savings and hence, provides more theory, which predicts that there is a strong long-run
room for a much better distribution of funds. Therefore, correlation between money growth and inflation in the
price stability is a widely sought goal as the appropriate economy (Frain, 2004).
objective of monetary policy and today, it becomes one By definition, fractional reserve is the modern
of the primary considerations of central banks around the banking practice in which, private banks have to keep a
world (Kadušić et al., 2011). small fraction of the amount deposited in reserve for the
In addition, in this modern economy, new money is future withdrawers and lend out the remainder for
created when commercial banks attempt to extend a borrowers. It will be decided based on a country’s
credit to their borrowers and investors with the central bank policies.

© 2015 Osman Sayid Hassan Musse, Abdelghani Echchabi and Hassanuddeen Abdul Aziz. This open access article is
distributed under a Creative Commons Attribution (CC-BY) 3.0 license.
Osman Sayid Hassan Musse et al. / American Journal of Economics and Business Administration 2015, 7 (3): 101.105
DOI: 10.3844/ajebasp.2015.101.105

For example, in the case of Malaysia, fractional correlation between average growth rates of money and
reserve requirement is 2% of the total amount deposited, average inflation rates. Moreover, this correlation remains
implying that commercial banks are required to keep strong even when countries with higher average inflation
only two percent for every amount deposited in their rates are removed from the sample size.
respective banks and they have a right to lend out the For the same purpose, Chimobi and Uche (2010)
remaining 98% to loan seekers, resulting in an increase investigated the relationship between money, inflation
in money supply, which is known to be the main source and output in the context of Nigeria employing the
of inflation and instability in prices in the current cointegration and Granger-causality test with annual data
economic system (Meera and Larbani, 2006). In the case for the period of 1970-2005. They concluded that there is
of the United States of America the requirement is 3%,
no cointegration between money supply and inflation;
while 1.5% for the United Kingdom.
however, money supply was found to be the cause for
Accordingly, the current study attempts to examine
both output and inflation under Granger test.
the above claim i.e., the influence of the current practice
Using the same method as Chimobi and Uche (2010),
of money creation by the commercial banks on the
Simwaka et al. (2012) examined the relationship
inflation in the GCC countries. The money creation
between money supply and inflation in the context of
process in the banking system is measured with both
Malawi and ended up with same conclusion of Chimobi
outstanding deposits and loans of the commercial banks.
and Uche (2010) in the case of Nigeria stating that the
The remaining part of this paper is organised as
increase of money supply is the main cause for inflation
follows: The second section discusses the concept of
money and debt creation and its relationship with in Malawian case.
inflation and the following section briefly describes the In his study, Lozano (2008) attempted to examine the
data used and results obtained. The final section links between budget deficit, money growth and inflation
discusses the conclusions and implications of the in the context of Colombia, but with a different method
research findings. employed in the above studies, namely, vector error
correction model with quarterly based data that covers
Literature Review the period of 25 years. However, he ended with a similar
result that indicates close relationship between inflation
Credit creation plays vital role in this modern and money growth as well as between money growth
economy in terms of financing economic activities such and fiscal deficit.
as trade, agriculture, investments and personal financing With the same variables; money growth and inflation,
i.e., home, car financing (Hasan, 2008). Generally, debt but in the context of Sri Lanka, Madurapperuma (2007)
creation occurs when commercial banks in the present studied factors behind inflation concluding that the
monetary system issue loans to their borrowers and current inflation is due to the expansion of money supply
investors. In doing so, they are causing changes to the in the country’s economy.
equilibrium of money supply level, disrupting the In a more comprehensive analysis, the causality test
balance between the supply and demand for goods and was used to examine the relationship between budget
services while influencing the interest rate relative deficit, monetary mass and inflation in three transition
(Call and Cochran, 2000). economies i.e., Albania, Romania and Bulgaria reporting
On the other hand, inflation is due to excessive that budget deficit has expanded money supply in the
money creation that was originated either by private or above three countries, it has tended to depreciate the
central banks (Madurapperuma, 2007). It is defined as an exchange rate and it has leaded to inflation rate volatility.
increase in general price level of goods and services. In other words, the study figured out that public financing
There are many theories to elaborate the relationship through issuing bonds is the main cause for the increase of
between money supply, money demand and inflation. money supply and then inflation rate volatility in the case
The most popular among them is the Quantity Theory of of Albania, Bulgaria and Romania (Milo, 2012).
Money (Yue and Leung, 2011). Based on this theory, On the other hand, Kwon et al. (2006) examined a
debt creation is the root cause of inflation and economic sample of 71 countries with 42 periods from 1963 to
illness in the present economic system. 2004) employing panel data analysis. They found that
In the empirical literature, the relationship between the average annual growth of money exceeded the
the money supply and inflation has received much average inflation growth about 4 per cent during the
attention from researchers. For instant, Frain (2004) study period and testing debt growth and inflation rate;
studied the relationship between money growth and therefore they concluded that the debt growth is
inflation applying coefficient model with sample of multi- significantly associated with high inflation in high debt
country data set. The author found that there is strong countries than in low debt countries.

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DOI: 10.3844/ajebasp.2015.101.105

Overall, the major difference between this study and the Infl = + β1 L + (1)
above few studies is centred on variables that were used in
the analysis. Specifically, the authors investigated the Infl = + β1 Dep + (2)
relationship between debt growth and inflation growth,
while the above studies examined the relationship between Based on the above model, the following hypotheses
money supply growth and inflation rate. Both approaches were established:
have concluded that money growth/debt growth is the
primary cause of inflation in the economy and in this • H1: The amount of outstanding loans has a positive
modern economy money is equal to debt. influence on the inflation rates in GCC countries.
With a similarity in the variables emphasised, Metin • H2: The amount of outstanding deposits has a
(1998) examined the relationship between budget deficit positive influence on the inflation rates in GCC
and inflation for Turkish economy using multivariate
countries.
cointegration as a tool for analysis ending up with a
conclusion that budget deficit is significantly affecting
the inflation level in Turkey. In order to test the above hypotheses, the study uses
On the other hand, for the same purpose, but panel regression analysis. For this matter, the analysis
focusing on price stability and inflation rate estimates the Pooled Ordinary Least Square (POLS)
correlations, Kadušić et al. (2011) studied inflation and model and subsequently uses the Breusch-Pagan
price stability in case of Yugoslavia. They concluded Lagrangian Multiplier (LM) test to verify the suitability
that high inflation rate may cause long lasting damage of POLS for this model.
to the whole economy, while a failure to regulate the
supply of money leads to destroy the value of money and Findings
causes price instability for goods and service.
Table 1 summarises selected parameters of the used
To investigate the relation between money creation variable. Specifically, the table shows a mean of 52.21
through fractional reserve practices and price stability in for the outstanding deposits, 55.22 for loans and 4.12 for
the context of MENA countries, Musse et al. (2014) the inflation levels. Similarly, the series recorded
examined the influence of money creation on the price standard deviation of 21.5 for outstanding deposits,
stability using yearly based data from 2005 to 2011 19.74 for loans and 4.33 for inflation. The Skewness and
and applying panel regression analysis based on the Kurtosis figures indicate that the series are slightly
pooled data set with a result that neither outstanding positively skewed, however, this did not have a significant
deposits nor outstanding loans do have a significant impact on their normality distribution as shown by the
influence on inflation. probability values of the Jarque-Bera test. Hence, generally
In a nutshell, the above studies are in line with the the data appears to be adequate for further analyses.
general monetary theories, which indicates that there is a Further, Table 2 presents the correlation between the
strong relationship between money supply and inflation three variables of the study. Mainly the high correlation
rate except Musse et al. (2014) study, which contradicted between the outstanding deposits and loans is relatively
with general prediction of monetary theory. Therefore, high. This demonstrates the current practice of money
this study tends to investigate the effect of debt creation creation by commercial banks through debt
in the commercial banking system on price stability and multiplication and fractional reserve banking (Meera and
Larbani, 2006). In addition, inflation is negatively
inflation rate and particularly, it attempts to examine the
correlated with both deposits and loans. Nevertheless,
monetary practices with the general belief of the the correlation is relatively negligible.
monetary theory. In order to test the above claims and initial results,
the study formulated two main hypotheses. The latter
Methodology suggest that both outstanding loans (H1) and deposits
(H2) have a significant positive impact on inflation.
The study uses three main variables, namely,
These hypotheses were tested through panel ordinary
outstanding deposits, outstanding loans and inflation least square and are reported in Tables 3 and 4.
for Qatar, Kuwait, Oman, Saudi Arabia and United In this regard, the results indicate that outstanding loans
Arab Emirates. These countries were selected based do not have an impact on inflation. Hence, hypothesis 1 is
on data availability, this is what justifies the exclusion not supported. Similarly, the findings revealed that
of Bahrain. The data spans from 2008 through 2013, outstanding deposits do not have an impact on inflation.
for all the mentioned countries. The data were Hence, hypothesis 2 is neither supported. This is in line
obtained from the World Bank and International with Musse et al. (2014). This implies that the fractional
Monetary Fund (IMF) databases. Accordingly, the reserve system does not necessarily promote inflation,
model can be written as follows: especially if it is not abused by the dominating parties.

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DOI: 10.3844/ajebasp.2015.101.105

Table 1. Descriptive analysis Furthermore, these findings imply that this form of
Deposits Loans Inflation money, i.e., fiat money, just like other kinds of money,
Mean 52.21032 55.22816 4.129318 can be used as medium of exchange as long as it is not
Median 47.27689 47.45675 3.203396 abused by the issuing authorities and/or speculators.
Maximum 99.43831 102.7010 15.05015 Hence, beside the nature of money itself, the
Minimum 25.82108 34.11969 -4.863278 community’s behaviour is what can help achieving the
Std. Dev. 21.50095 19.74673 4.336916 underlying purpose of money. Thus, an important criterion
Skewness 0.918928 1.113289 0.709244 for selecting an “alternative money” would be the extent
Kurtosis 2.839119 2.937108 3.599920 to which the latter can be abused and manipulated by
Jarque-Bera 4.112681 5.995276 2.866184 different parties. This is particularly relevant to Islamic
Probability 0.127921 0.049905 0.238570 banking and finance, whereby there were recently many
attempts to develop alternative currencies as the basis for
Table 2. Correlation matrix the Islamic banking and finance transactions.
Deposits Loans Inflation
Deposits 1 0.90 -0.25
Loans 0.90 1 -0.21
Conclusion
Inflation -0.25 -0.21 1 Though the current study has significant
contributions, it still has some limitations that need to be
Table 3. Panel least squares addressed in the future studies in this area. The main
Variable Coefficient Std. Error t-Statistic Prob. limitation of the study is the use of data for seven years
C 6.768158 2.414957 2.802600 0.0093 only and for 5 GCC countries only. Hence, future studies
Loans -0.047781 0.041255 -1.158183 0.2569 are required to extend the study by including larger
number of countries and for a longer periods of time.
Table 4. Panel least squares Similarly, the future studies are recommended to include
Variable Coefficient Std. Error t-Statistic Prob. other macro-economic variables for a more
C 6.807494 2.114503 3.219430 0.0033 comprehensive analysis.
Deposits -0.051296 0.037543 -1.366342 0.1831
Acknowledgment
Hence, it can be concluded that the money creation The authors would like to thank the anonmous
through debt does not have any influence on the inflation reviewers as well as the associate editor for their efforts
variation across the GCC countries. and valuable feedback.

Discussion Funding Information

The main purpose of this study was to examine the The authors have no support or funding to report.
possible influence of the current commercial banks’
money creation process on the price stability in the case
of GCC countries. The results clearly showed that
Author’s Contributions
neither outstanding deposits nor loans have significant Osman Said Hassan Musse: Problem formulation
influence on the inflation levels in these countries. and literation review.
This finding has significant implications for the Abdelghani Echchabi: Problem identification, data
theory, the policy makers as well as to the practitioners. collection and analysis.
In this regard, the findings are inconsistent with the Hassanuddeen Abdul Aziz: Theoretical
contemporary economics and finance theory claiming underpinings and implicatiions.
that the process of money creation practiced by the Ethics
commercial banks influences the inflation levels in the
economy and contributes to price instability, particularly This article is original and contains unpublished
in the case of selected GCC countries. This indicates that material. The corresponding author confirms that all of
the process of money creation has been thoroughly the other authors have read and approved the manuscript
and no ethical issues involved.
managed by the authorities in these countries b
considering the totality of the macroeconomic indicators.
Particularly, the inflation rates were closely monitored to References
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DOI: 10.3844/ajebasp.2015.101.105

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