What is fractional reserve banking

The amount of money created by banks depends on the size of the deposit and the money multiplier. Calculate the change in money supply given the money multiplier, an initial deposit and the reserve ratio. To understand the process of money creation, let us create a hypothetical system of banks.

We will focus on two banks in this system: Anderson Bank and Brentwood Bank. Mathematically, the relationship between reserve requirements rr , deposits, and money creation is given by the deposit multiplier m. The deposit multiplier is the ratio of the maximum possible change in deposits to the change in reserves. Thus, with a required reserve ratio of 0. The money multiplier measures the maximum amount of commercial bank money that can be created by a given unit of central bank money.

When you think of money, what you probably imagine is commercial bank money. This consists of the dollars in your bank account — the money that you use when you write a check or use a debit or credit card.

This money is created when commercial banks make loans to companies or individuals. Central bank money, on the other hand, is the money created by the central bank and used within the banking system. It consists of bank reserves held in accounts with the central bank, as well as physical currency held in bank vaults. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend the commercial bank money that they can legally create is a multiple of reserves; this multiple is the reciprocal of the reserve ratio.

We can derive the money multiplier mathematically, writing M for commercial bank money loans , R for reserves central bank money , and RR for the reserve ratio. We start with the reserve ratio requirement that the the fraction of deposits that a bank keeps as reserves is at least the reserve ratio:.

The above equation states that the total supply of commercial bank money is, at most, the amount of reserves times the reciprocal of the reserve ratio the money multiplier. Money Creation and the Money Multiplier : The graph shows the theoretical amount of money that can be created with different reserve requirements. If banks lend out close to the maximum allowed by their reserves, then the inequality becomes an approximate equality, and commercial bank money is central bank money times the multiplier.

If banks instead lend less than the maximum, accumulating excess reserves, then commercial bank money will be less than central bank money times the theoretical multiplier. In theory banks should always lend out the maximum allowed by their reserves, since they can receive a higher interest rate on loans than they can on money held in reserves.

Theoretically, then, a central bank can change the money supply in an economy by changing the reserve requirements. In reality, it is very unlikely that the money supply will be exactly equal to reserves times the money multiplier. Explain factors that prevent the money multiplier from working empirically as it does theoretically. The money multiplier in theory makes a number of assumptions that do not always necessarily hold in the real world.

It assumes that people deposit all of their money and banks lend out all of the money they can they hold no excess reserves. It also assumes that people instantaneously spend all of their loans.

In reality, not all of these are true, meaning that the observed money multiplier rarely conforms to the theoretical money multiplier. First, some banks may choose to hold excess reserves. In the decades prior to the financial crisis of , this was very rare — banks held next to no excess reserves, lending out the maximum amount possible. During this time, the relationship between reserves, reserve requirements, and the money supply was relatively close to that predicted by economic theory.

The presence of these excess reserves suggests that the reserve requirement ratio is not exerting an influence on the money supply. Monetary Base : The monetary base is the sum of currency and reserves held in accounts at the central bank.

Therefore, the bank that accepted the deposit from Customer A need to hold only 25 Dollars in the form of cash and it is free to do whatever it wants with the other 75 Dollars.

Similarly, other customers deposit money and the bank likewise loans them out to other customers. In this way, your deposit of Dollars multiplies to a large amount by the system of fractional reserve banking.

In other words, banks must hold a fraction of their reserves in cash and can lend out the rest to the other customers. Supposing all customers who have deposited Dollars want their entire money back on day based on some economic event that would have happened. The event can also be due to the value of the assets that the bank bases its loans on going down. This depreciation in the leverage or the ramping up of loans based on the value of the underlying asset is known as leverage. Take for example, the loan that the bank would have made from the Dollars deposited by customer A.

Since only 25 Dollars are to be held in reserve, the bank can loan out the other 75 Dollars. But when the central bank decides to print money, it literally can just create it. It could literally print physical money. Or it can create electronic money, which has the same exact effect. So let's say the central bank, it goes out there and it goes out there and it prints three-- and we'll just focus on the physical right now.

It's a little bit easier to conceptualize. And it just goes out there and it prints three physical dollar bills. Now it has to figure out, how does it get it into circulation? How does it get it into the economy? And it does not just put it into a helicopter and drop it from that helicopter. Sometimes, in certain circumstances, it can lend to this directly to banks, certain types of banks, member banks.

But the typical way that this enters circulation is that the central bank will use this newly created money, this newly created reserves I should say, to go out into the open market and buy securities.

And they typically buy very safe securities, typically government debt. So they will go out there and they will put this into circulation.

And in exchange they are buying securities from the open market. So then these securities from the open market will go to the central bank. So these are securities, or maybe we could call them bonds.

And once they do that, then whoever had these before, whoever was the owner of the securities before, they just sold them. Now they have these dollar bills. And they could either directly spend those dollar bills or they could deposit those dollar bills in a bank. If they spend the dollar bills, then whoever they gave those dollar bills to at some point would want to deposit it in a bank.

Some way, by buying these securities, someone now has these dollar bills. And they will deposit them in a private bank. So let's draw that. So right over here is a private bank. And now it has the dollar bills. It has these reserves now. It has the reserves. Now, that's not the end of the story. This money can now be lent. And this is key, because this is what's typical in most market economies where they have fractional reserve lending.

So fractional reserve lending, which is a bit strange, because you are telling the person who just deposited this money right here, that you can go at any time and you can take this money out.

We've got this money for you. You can trust us. You don't have to be paranoid about what's going on with this money. But the reality is that this bank is allowed to keep only a fraction of these reserves, and lend to the rest of it out.

In order for this system to not be super fragile, the Central Bank then also insures these banks. But we'll talk about that into more depth. But here. I just want to show you how the money is created in this fractional reserve lending system.

So this bank right over here says, well I have to keep a little bit of these reserves in case that guy comes. The probability of all my customers coming on the same day and asking for all of their money is low.