Fractional Reserve Banking

Fractional Reserve Banking Banking Financial Regulation Monetary Policy Central Banks
Fractional reserve banking is a regulation in the banking industry whereby banks (and other similar institutions) keep reserves that are less than their total deposits.
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Fractional Reserve Banking

Definition

Fractional reserve banking is a banking system in which banks are required to keep only a fraction of their depositors’ balances in reserve as cash or other highly liquid assets. This allows banks to use the remaining deposits to make loans and create credit. Central banks set the reserve requirements which dictate the minimum percentage of deposits that must be held in reserve.

Examples

  1. Example 1: Reserve Requirement of 10%

    • A bank receives $1,000 in deposits and is required to keep 10% in reserve.
    • The bank keeps $100 in reserve and lends out the remaining $900.
    • This lending process generates new money and increases the money supply in the economy.

  2. Example 2: Reserve Requirement of 20%

    • A bank receives $5,000 in deposits with a 20% reserve requirement.
    • The bank holds $1,000 in reserve and is able to lend out $4,000.
    • The loaned amount is then deposited and re-loaned, amplifying the effect of the initial deposit.

Frequently Asked Questions (FAQ)

Q1: What is the primary benefit of fractional reserve banking?

  • A1: The primary benefit is its ability to expand the money supply through the lending process, which can stimulate economic growth.

Q2: Why do central banks impose reserve requirements?

  • A2: Reserve requirements are imposed to ensure stability in the banking system and to control the money supply.

Q3: Can a bank run out of cash in a fractional reserve system?

  • A3: Yes, if many depositors demand their money back simultaneously, a bank may face liquidity issues. This is why central banks act as lenders of last resort.

Q4: How does fractional reserve banking affect interest rates?

  • A4: By influencing the supply of money available for loans, fractional reserve banking can impact interest rates. More lending capacity typically leads to lower interest rates.

Q5: What is the reserve ratio?

  • A5: The reserve ratio is the fraction of deposits that a bank is required to hold in reserve and not lend out.
  • Reserve Requirement: The minimum amount of reserves a bank must hold against deposits.
  • Money Multiplier: The ratio of the increase in money supply to the initial deposit. It shows how money supply is magnified.
  • Central Bank: The institution responsible for managing the nation’s money supply and monetary policy.
  • Liquidity: The availability of liquid assets to a bank or company.
  • Bank Run: When a large number of bank’s customers withdraw their deposits simultaneously due to concerns about the bank’s solvency.

Online References

Suggested Books for Further Studies

  1. “Money, Bank Credit, and Economic Cycles” by Jesús Huerta de Soto
  2. “Man, Economy, and State with Power and Market” by Murray Rothbard
  3. “The Mystery of Banking” by Murray Rothbard
  4. “Principles of Economics” by N. Gregory Mankiw
  5. “Monetary Theory and Policy” by Carl E. Walsh

Fundamentals of Fractional Reserve Banking: Finance Basics Quiz

### 1. What is fractional reserve banking? - [ ] A system where banks keep 100% of deposits in reserve. - [x] A system where banks keep a fraction of deposits in reserve. - [ ] A system where there are no reserve requirements. - [ ] A system where all deposits are lent out without reserve. > **Explanation:** Fractional reserve banking refers to the practice where banks keep only a fraction of their deposits on reserve and loan out the rest. ### 2. What determines the reserve fraction that banks must hold? - [x] Central bank's reserve requirements. - [ ] Individual bank policies. - [ ] Market demand. - [ ] International regulations. > **Explanation:** Reserve requirements are set by central banks and dictate the minimum fraction of deposits that banks must hold. ### 3. Why is fractional reserve banking significant for the economy? - [ ] It decreases money supply. - [x] It expands money supply through credit creation. - [ ] It eliminates the need for a central bank. - [ ] It increases liquidity without risk. > **Explanation:** Fractional reserve banking is significant because it allows banks to create credit, thereby expanding the money supply and potentially stimulating economic growth. ### 4. What can trigger a bank run? - [x] A large number of depositors withdrawing funds simultaneously. - [ ] High reserve requirements. - [ ] Increased lending. - [ ] Central bank interventions. > **Explanation:** A bank run can occur when a large number of depositors simultaneously withdraw their funds due to concerns about the bank’s solvency. ### 5. If a bank has $10,000 in deposits and a 10% reserve requirement, how much can it loan out? - [ ] $10,000 - [x] $9,000 - [ ] $1,000 - [ ] $10,900 > **Explanation:** With a 10% reserve requirement, the bank must hold $1,000 in reserve and can loan out the remaining $9,000. ### 6. Which institution is known as the lender of last resort? - [ ] Commercial banks - [x] Central banks - [ ] Investment firms - [ ] Hedge funds > **Explanation:** Central banks act as lenders of last resort to ensure stability in the banking system. ### 7. How does fractional reserve banking impact interest rates? - [x] By influencing the money supply available for loans. - [ ] By determining bank profits directly. - [ ] By setting global monetary policies. - [ ] By controlling inflation directly. > **Explanation:** Fractional reserve banking impacts interest rates by influencing the supply of money available for loans, with more lending capacity generally leading to lower interest rates. ### 8. What is the money multiplier? - [ ] The ratio of bank profits to deposits. - [x] The ratio of the total money supply to the initial deposit. - [ ] The cash reserves exceeding the required amount. - [ ] The interest earned on reserves. > **Explanation:** The money multiplier is the ratio of the change in the total money supply to an initial deposit, showing how money supply can be magnified through the banking system. ### 9. What are reserves in the context of fractional reserve banking? - [x] The cash or liquid assets that banks are required to keep on hand. - [ ] The loans that banks issue to consumers. - [ ] The foreign currencies held by banks. - [ ] The total amount of a bank's deposits. > **Explanation:** Reserves refer to the amount of cash or highly liquid assets that banks are required to keep to meet regulatory requirements and ensure stability. ### 10. What can reduce the risk of bank runs in fractional reserve banking? - [x] Central bank interventions and insurance schemes. - [ ] Lowering reserve requirements. - [ ] Increasing interest rates. - [ ] Reducing the number of loans. > **Explanation:** Central bank interventions and insurance schemes, such as deposit insurance, can help reduce the risk of bank runs by providing security to depositors and ensuring liquidity in the banking system.

Thank you for diving into the structured world of fractional reserve banking. Stay informed and continue building your financial acumen!

Wednesday, August 7, 2024
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