Uncovering the Mystery of Fractional Reserve Banking: How it Works and Its Impact on the Economy

So what is fractional reserve banking?

Fractional reserve banking is a system in which commercial banks are allowed to hold only a fraction of their deposits in reserve and lend out the rest. In other words, banks are allowed to create new money by lending out a portion of their deposits.

Under this system, banks are required to maintain a certain percentage of their deposits in reserve (also known as the reserve ratio), while the remainder can be lent out to borrowers. For example, if the reserve ratio is 10%, a bank with $100 in deposits can lend out $90 to borrowers, while keeping $10 in reserve.

The fractional reserve system allows banks to expand the money supply through the creation of new loans, which can stimulate economic activity. However, it also introduces some degree of risk, as banks may not have sufficient reserves to meet the demands of depositors if a large number of them try to withdraw their funds at the same time. This is known as a bank run.

To mitigate this risk, central banks, such as the Federal Reserve in the United States, often act as lenders of last resort, providing banks with the necessary reserves to meet the demands of their depositors. This helps to maintain the stability of the financial system.

Imagine that you have $100 in your checking account at a bank. The bank is required to maintain a reserve ratio of 10%, which means that it must keep at least 10% of its deposits in reserve. In this case, the bank must keep $10 in reserve and can lend out the remaining $90.

Let’s say that the bank lends this $90 to a borrower, who uses it to purchase a new car. The car dealership deposits the $90 in its own account at the same bank. Now, the bank has a total of $190 in deposits ($100 from you and $90 from the car dealership), but it only has $10 in reserve.

Under the fractional reserve system, the bank is allowed to lend out a portion of its deposits, even though it doesn’t have the full amount in reserve. In this case, it could lend out an additional $81 (90% of $90) to another borrower, while still maintaining the required reserve ratio of 10%.

As you can see, fractional reserve banking allows banks to create new money by lending out a portion of their deposits. However, it also introduces some degree of risk, as banks may not have sufficient reserves to meet the demands of depositors if a large number of them try to withdraw their funds at the same time.