Fractional reserve banking

Definition

Fractional reserve banking is a banking system in which banks are required to keep only a fraction of their depositors' funds in reserve, while the rest can be used for lending and investment. This practice enables banks to create money through lending, as they can issue more loans than the actual deposits held, which can stimulate economic growth but also introduces risks like bank runs and inflation.

5 Must Know Facts For Your Next Test

1. In fractional reserve banking, if the reserve requirement is set at 10%, a bank can lend out $90 for every $100 in deposits it receives.
2. This system allows for greater liquidity in the economy, as it increases the money supply through loans and investments.
3. Fractional reserve banking plays a critical role in enabling banks to support businesses and consumers by providing loans for various needs.
4. However, if too many people withdraw their deposits at once, it can lead to a bank run, since banks do not have enough cash on hand to cover all withdrawals.
5. The practice can lead to inflation if too much money is created without corresponding economic growth, as more money chases the same amount of goods and services.

Review Questions

• How does fractional reserve banking contribute to the overall liquidity in an economy?
  • Fractional reserve banking increases overall liquidity by allowing banks to lend out a portion of their deposits, which generates new money through the loaning process. When banks lend more than they hold in actual reserves, they effectively create new money that circulates in the economy. This influx of capital supports consumer spending and business investments, thereby stimulating economic activity and growth.
• Discuss the potential risks associated with fractional reserve banking and how they might affect financial stability.
  • One major risk of fractional reserve banking is that it can lead to bank runs if depositors lose confidence and attempt to withdraw their funds en masse. Since banks only keep a fraction of deposits in reserves, they may not have enough cash to meet withdrawal demands. Additionally, excessive lending without adequate reserves can inflate asset bubbles and contribute to broader financial instability if economic downturns occur, impacting borrowers' ability to repay loans.
• Evaluate the implications of fractional reserve banking on monetary policy and its ability to manage economic cycles.
  • Fractional reserve banking has significant implications for monetary policy because it allows central banks to influence money supply and interest rates through mechanisms like reserve requirements. By adjusting these requirements, central banks can either encourage lending during economic downturns or tighten money supply during inflationary periods. However, reliance on this system also poses challenges; if banks lend excessively without sufficient oversight, it may undermine monetary policy efforts and lead to unsustainable debt levels that could destabilize the economy.

Related terms

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

Money Multiplier: A factor that quantifies the amount of money that banks generate with each dollar of reserves, indicating how much money supply can be increased through the lending process.

Bank Run: A situation where a large number of depositors withdraw their funds simultaneously due to concerns about the bank's solvency, which can lead to the bank's collapse.