Fractional Reserve

Definition

Fractional reserve is a banking system where banks are required to hold only a fraction of their total deposits as reserves, while the remaining portion can be loaned out. This practice allows banks to create money through the process of credit creation, which is a central aspect of how banks function in the modern economy.

5 Must Know Facts For Your Next Test

1. The fractional reserve system allows banks to lend out a portion of their deposits, enabling them to create new money through the process of credit creation.
2. The reserve requirement, set by the central bank, determines the fraction of deposits that banks must hold as reserves, limiting the extent of credit creation.
3. As banks lend out a portion of their deposits, the money supply expands, leading to the multiplier effect, where a single deposit can generate multiple loans and increase the overall money supply.
4. The fractional reserve system is a key mechanism through which central banks can influence the money supply and implement monetary policies to achieve economic objectives.
5. The ability of banks to create money through the fractional reserve system is a central feature of the modern banking system and has significant implications for the management of the overall economy.

Review Questions

• Explain the concept of fractional reserve banking and how it allows banks to create money.
  • In a fractional reserve banking system, banks are required to hold only a fraction of their total deposits as reserves, while the remaining portion can be loaned out. This practice enables banks to create new money through the process of credit creation. When a bank receives a deposit, it can lend out a portion of that deposit to a borrower, who then deposits the borrowed funds in another bank. This process continues, with each subsequent loan creating additional deposits, effectively expanding the money supply. The extent of this credit creation is limited by the reserve requirement set by the central bank, which determines the fraction of deposits that banks must hold as reserves.
• Describe the role of the central bank in the fractional reserve system and its impact on the money supply.
  • The central bank plays a crucial role in the fractional reserve system by setting the reserve requirement, which determines the minimum fraction of deposits that banks must hold as reserves. By adjusting the reserve requirement, the central bank can influence the ability of banks to create money through credit creation. A lower reserve requirement allows banks to lend out a larger portion of their deposits, leading to a greater expansion of the money supply. Conversely, a higher reserve requirement limits the extent of credit creation, reducing the growth of the money supply. Through this mechanism, the central bank can implement monetary policies to achieve economic objectives, such as controlling inflation or stimulating economic growth.
• Analyze the potential risks and benefits associated with the fractional reserve system and its implications for financial stability.
  • The fractional reserve system offers both potential benefits and risks for the financial system and the broader economy. On the positive side, the ability of banks to create money through credit creation can facilitate economic growth by providing access to credit and expanding the money supply. This can support investment, consumption, and overall economic activity. However, the fractional reserve system also carries inherent risks, such as the potential for bank runs and financial crises. When a significant portion of deposits are loaned out, banks become vulnerable to liquidity shocks, where a large number of depositors may simultaneously withdraw their funds, leading to a lack of available reserves. This can trigger a cascade of bank failures and broader financial instability. Additionally, the expansionary nature of credit creation can contribute to asset bubbles and inflationary pressures if not properly managed by the central bank. Consequently, the regulation and oversight of the fractional reserve system by policymakers is crucial for maintaining financial stability and promoting sustainable economic growth.

Related terms

Central Bank:

The central banking authority that sets monetary policies, including the required reserve ratio that determines the amount of reserves banks must hold.

Credit Creation:

The process by which banks can expand the money supply by lending out a portion of their deposits, effectively creating new money in the form of loans.

Reserve Requirement:

The minimum fraction of deposits that banks must hold as reserves, as set by the central banking authority, which limits the amount of credit creation.