What is Fractional Reserve Banking?

What is Fractional Reserve Banking?

What is Fractional Reserve Banking? Jonathan Poland

Fractional-reserve banking is a system in which banks are only required to hold a fraction of the deposits they receive as reserves. This means that banks can lend out a portion of the money that is deposited with them, which can help to stimulate the economy.

For example, let’s say that you deposit $100 in a bank. The bank is only required to keep a fraction of that money, say 10%, as reserves. This means that the bank can lend out $90 of your money to someone else. That person can then use that money to buy goods and services, which will help to create jobs and stimulate the economy.

Fractional reserve banking can be a powerful tool for economic growth, but it also comes with some risks. If too many people try to withdraw their money at the same time, the bank may not have enough reserves to cover all of the withdrawals. This can lead to a bank run, which can have a devastating impact on the economy.

To prevent bank runs, central banks typically set reserve requirements for banks. These requirements specify the minimum amount of reserves that banks must hold. Central banks can also use other tools, such as open market operations, to influence the amount of money in circulation.

Fractional reserve banking is a complex system, but it is an essential part of the modern economy. It allows banks to lend money, which helps to stimulate the economy. However, it also comes with some risks, which central banks must manage.

Here are some additional details about fractional reserve banking:

  • The reserve requirement is the percentage of deposits that banks are required to hold as reserves.
  • The required reserve ratio is the ratio of required reserves to total deposits.
  • Excess reserves are the reserves that banks hold over and above the required reserve ratio.
  • The money multiplier is the ratio of the money supply to the monetary base.
  • The monetary base is the sum of currency in circulation and bank reserves.

Fractional reserve banking can be used to create money. When a bank lends money, it creates a new deposit in the borrower’s account. This new deposit is then available to be spent, which can create more new deposits. This process can continue until the entire amount of the loan is repaid.

Fractional reserve banking can also be used to destroy money. When a bank makes a loan, it creates a new deposit in the borrower’s account. However, if the borrower repays the loan, the bank must destroy the deposit. This can reduce the amount of money in circulation.

Fractional reserve banking is a complex system, but it is an essential part of the modern economy. It allows banks to lend money, which helps to stimulate the economy. However, it also comes with some risks, which central banks must manage.

How much less money would a bank make if it lent out 50% of its deposits instead of 90%?

To illustrate the impact of lending out 50% of deposits instead of 90%, let’s use a simplified example. Assume the bank has $1,000,000 in deposits and charges an annual interest rate of 5% on loans.

Scenario 1:
Bank lends out 90% of its deposits
Total deposits: $1,000,000
Amount lent out: $1,000,000 * 0.90 = $900,000
Annual interest income: $900,000 * 0.05 = $45,000

Scenario 2: Bank lends out 50% of its deposits
Total deposits: $1,000,000
Amount lent out: $1,000,000 * 0.50 = $500,000
Annual interest income: $500,000 * 0.05 = $25,000

Comparing the two scenarios, the difference in interest income: $45,000 (Scenario 1) – $25,000 (Scenario 2) = $20,000 or 44% less profitable.

In this simplified example, the bank would make $20,000 less in annual interest income if it lent out 50% of its deposits instead of 90%. Keep in mind that this example does not account for other factors such as operating costs, interest payments to depositors, default risk, or regulatory requirements. The actual impact on a bank’s income would depend on a variety of factors, including the specific interest rates charged on loans and paid on deposits, and the bank’s overall business model.

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