Fractional Reserve Banking

Definition

Fractional reserve banking is a banking system where banks hold only a fraction of their customers' deposits as reserves, and use the rest to make loans. This practice allows banks to expand the money supply and create new money, but also introduces the risk of bank runs and financial instability.

5 Must Know Facts For Your Next Test

1. Fractional reserve banking allows banks to lend out a portion of their deposits, which increases the overall money supply in the economy.
2. The reserve requirement set by the central bank determines the maximum amount of loans a bank can make relative to its reserves, and thus the money multiplier effect.
3. Fractional reserve banking can create financial instability, as a loss of confidence in the banking system can trigger a bank run, leading to the collapse of banks and the money supply.
4. The Federal Reserve's role as the central bank is to regulate the money supply and maintain financial stability, in part through the setting of reserve requirements for banks.
5. Measuring the money supply, such as M1 and M2, is important in understanding the impact of fractional reserve banking on the economy.

Review Questions

• Explain how fractional reserve banking allows banks to create new money and expand the money supply.
  • In a fractional reserve banking system, banks are only required to hold a fraction of their customers' deposits as reserves, typically set by the central bank. This allows banks to lend out the remaining portion of the deposits, which then get redeposited in the banking system, enabling banks to make additional loans. This process, known as the money multiplier effect, leads to an expansion of the overall money supply in the economy.
• Describe the role of the central bank in regulating fractional reserve banking and its impact on financial stability.
  • The central bank, such as the Federal Reserve, plays a crucial role in regulating fractional reserve banking. By setting the reserve requirement, the central bank determines the maximum amount of loans banks can make relative to their reserves, which in turn affects the money multiplier and the overall money supply. Additionally, the central bank can use monetary policy tools, like adjusting interest rates, to influence the lending and borrowing behavior of banks, with the goal of maintaining financial stability and preventing the risks associated with fractional reserve banking, such as bank runs.
• Analyze how the measurement of money supply, such as M1 and M2, is related to the concept of fractional reserve banking and its impact on the economy.
  • The measurement of money supply, including M1 (currency, demand deposits, and other liquid assets) and M2 (M1 plus savings deposits, small time deposits, and money market mutual funds), is directly influenced by the practice of fractional reserve banking. As banks lend out a portion of their deposits, the money supply expands through the money multiplier effect. This expansion of the money supply can have significant macroeconomic implications, affecting inflation, interest rates, and economic growth. By monitoring the changes in money supply measures, policymakers and economists can better understand the impact of fractional reserve banking on the overall economy and make informed decisions regarding monetary policy and financial regulations.

Related terms

Reserve Requirement: The minimum fraction of customer deposits that banks must hold as reserves, as mandated by the central bank or financial regulators.

Money Multiplier:

The process by which banks can use their reserves to create new money through the extension of loans, leading to an expansion of the money supply.

Bank Run: A situation where a large number of bank customers simultaneously withdraw their deposits, due to a loss of confidence in the bank's ability to repay, which can lead to the bank's failure.