Fractional Reserve Banking

Definition

Fractional reserve banking is a system in which banks are required to keep only a fraction of their deposits as reserves while they can lend out the remaining amount. This practice allows banks to create money through loans, as the deposits that are lent out can be deposited again, further amplifying the money supply. The balance between reserves and loans is crucial for the stability of the banking system and plays a significant role in the economy.

5 Must Know Facts For Your Next Test

1. Banks typically hold only a small percentage of deposits as reserves, with the remainder available for loans, which can lead to significant money creation in the economy.
2. The money multiplier effect shows how initial deposits can lead to greater amounts of money circulating in the economy through repeated lending and depositing.
3. If too many depositors withdraw their funds at once, it can lead to a bank run, highlighting the risks associated with fractional reserve banking.
4. Regulatory bodies monitor banks' reserve levels to ensure financial stability and prevent excessive risk-taking in lending practices.
5. Changes in reserve requirements by the central bank can directly influence lending practices and overall economic activity.

Review Questions

• How does fractional reserve banking enable banks to create money, and what is its impact on the overall money supply?
  • Fractional reserve banking allows banks to lend out a portion of their deposits while keeping only a fraction as reserves. When banks issue loans, these funds are often deposited back into the banking system, allowing for more loans to be created from those deposits. This cycle leads to an expansion of the money supply, as each deposit creates additional rounds of lending and depositing, multiplying the overall amount of money available in the economy.
• Discuss the relationship between fractional reserve banking and reserve requirements set by central banks.
  • Reserve requirements dictate how much of each deposit banks must hold in reserve. In fractional reserve banking, banks lend out any amount above this requirement. When central banks adjust these reserve requirements, it directly impacts how much money banks can create through lending. A lower reserve requirement allows for more lending and money creation, while a higher requirement restricts it, influencing economic activity and liquidity in the market.
• Evaluate the potential risks associated with fractional reserve banking and their implications for financial stability.
  • Fractional reserve banking carries risks such as bank runs, where too many customers withdraw their deposits simultaneously, leading to liquidity issues. If banks do not have enough reserves on hand due to excessive lending, it can result in insolvency and loss of public trust. Additionally, high levels of lending may lead to economic bubbles or credit crises if not managed properly. Thus, maintaining an appropriate balance of reserves is crucial for both individual bank stability and overall economic health.

Related terms

Reserve Requirement:

The minimum amount of reserves a bank must hold against deposits, determined by the central bank.

Money Multiplier:

A formula that quantifies the maximum amount of money that can be created in the banking system based on the reserve requirement.

Central Bank:

The institution responsible for managing a country's monetary policy and overseeing the banking system, including setting reserve requirements.