Fractional reserve banking

Definition

Fractional reserve banking is a banking system where banks hold only a fraction of their deposits as reserves and lend out the majority to borrowers. This practice enables banks to create money through lending, as each loan effectively increases the money supply within the economy. By not keeping all deposits in reserve, fractional reserve banking supports economic growth by facilitating more lending and investment.

5 Must Know Facts For Your Next Test

1. Fractional reserve banking emerged during the Middle Ages when banks started issuing more receipts for gold than the actual gold they held.
2. This system allows banks to lend out more money than they actually possess in deposits, effectively increasing the money supply in the economy.
3. Banks can use various financial instruments and practices, such as short-term loans and credit facilities, to manage their reserves and meet withdrawal demands.
4. The stability of fractional reserve banking relies on the assumption that not all depositors will withdraw their money at the same time, which is why confidence in the banking system is crucial.
5. Regulations often set the reserve requirement percentage, which dictates how much of deposits must be held in reserve and how much can be lent out.

Review Questions

• How does fractional reserve banking contribute to economic growth?
  • Fractional reserve banking contributes to economic growth by allowing banks to lend out a significant portion of their deposits. When banks provide loans, they effectively create new money in the economy, which facilitates investment and spending. This process leads to increased economic activity as businesses expand and consumers purchase goods and services, ultimately contributing to overall economic development.
• Evaluate the potential risks associated with fractional reserve banking, particularly during times of financial instability.
  • One major risk associated with fractional reserve banking is the possibility of a bank run, where many depositors attempt to withdraw their funds simultaneously due to fear of insolvency. Since banks only keep a fraction of deposits on hand, they may not have enough liquid assets to cover all withdrawals. This can lead to a loss of confidence in the banking system as a whole, potentially resulting in broader financial instability and economic downturn.
• Discuss how regulatory measures like reserve requirements impact the functioning of fractional reserve banking and its role in the economy.
  • Regulatory measures such as reserve requirements play a critical role in maintaining the stability of fractional reserve banking. By setting a minimum percentage of deposits that banks must hold as reserves, regulators aim to ensure that banks can meet withdrawal demands while still lending out funds to promote economic activity. These requirements help prevent excessive risk-taking by banks, ensuring that they maintain sufficient liquidity to handle potential crises. Ultimately, these regulations help balance the benefits of lending with the need for stability within the financial system.

Related terms

Money Supply: The total amount of money available in an economy at a particular time, including cash, coins, and balances held in bank accounts.

Reserve Requirement: The minimum amount of reserves that a bank must hold against its deposits, as mandated by regulatory authorities.

Bank Run: A situation where a large number of customers withdraw their deposits simultaneously, often due to fears that the bank will become insolvent.