Fractional reserve banking

Definition

Fractional reserve banking is a system where banks hold a fraction of their depositors' funds in reserve and use the rest for lending or investing. This practice allows banks to create new money through the lending process, effectively expanding the money supply within an economy. By only keeping a portion of deposits on hand, banks can generate more loans, leading to increased economic activity and growth.

5 Must Know Facts For Your Next Test

1. Fractional reserve banking enables banks to lend more than the amount of actual cash they hold, thereby stimulating economic growth.
2. The system relies heavily on trust, as depositors need to believe that they can withdraw their money whenever they want.
3. In times of financial crisis or panic, fractional reserve banking can lead to bank runs, where many customers withdraw funds simultaneously, threatening bank solvency.
4. Central banks monitor and regulate fractional reserve requirements to ensure financial stability and prevent excessive risk-taking by commercial banks.
5. The money created through loans can lead to inflation if it grows faster than the economy's ability to produce goods and services.

Review Questions

• How does fractional reserve banking contribute to the overall money supply in an economy?
  • Fractional reserve banking contributes to the money supply by allowing banks to lend out a portion of their deposits while keeping a fraction in reserve. This process means that when banks issue loans, they create new money in the form of deposits for borrowers. As these borrowers spend the money, it circulates and can be deposited into other banks, allowing for even more lending and further expanding the money supply.
• Evaluate the risks associated with fractional reserve banking for both banks and depositors.
  • The risks associated with fractional reserve banking include potential bank runs, where many depositors attempt to withdraw their funds simultaneously, exceeding the bank's available reserves. This scenario can lead to insolvency and loss of depositor savings. Additionally, banks may engage in risky lending practices in pursuit of higher profits, which could lead to defaults and ultimately threaten the bank's stability and broader economic health.
• Discuss how changes in reserve requirements can impact the economy and the effectiveness of monetary policy.
  • Changes in reserve requirements directly influence how much money banks can lend out. If the central bank lowers the reserve requirement, banks have more funds available for lending, which can stimulate economic growth by increasing consumer spending and business investment. Conversely, raising reserve requirements restricts lending, potentially slowing down economic activity. This dynamic is crucial for effective monetary policy as it allows central banks to control inflation and support economic stability through adjustments in the money supply.

Related terms

Reserve Requirement: The minimum amount of reserves that banks must hold against deposits, set by the central bank.

Money Multiplier: The factor by which a change in reserves will lead to a change in the total money supply, illustrating the impact of fractional reserve banking.

Liquidity: The ease with which assets can be converted into cash without affecting their market price, crucial for banks to meet withdrawal demands.