Fractional reserve banking is the system in which banks keep only a fraction of customer deposits as reserves and lend out the rest. It matters because lending helps households buy homes, businesses expand, and students pay for education. At the same time, it changes the total amount of money circulating in the economy.
Understanding it helps students see how everyday deposits can support much larger financial activity.
Key Facts
- Reserve ratio = required reserves / total deposits
- Required reserves = reserve ratio × deposits
- Excess reserves = total reserves - required reserves
- Money multiplier = 1 / reserve ratio, when banks lend all excess reserves and borrowers redeposit all loans
- Maximum new money created = initial excess reserves × money multiplier
- With a 10% reserve ratio, a 100 in reserves and can support up to $900 in new loans at the first bank
Vocabulary
- Fractional reserve banking
- A banking system in which banks keep part of each deposit as reserves and lend out the remaining amount.
- Reserve ratio
- The fraction of deposits that a bank must hold as reserves instead of lending.
- Required reserves
- The minimum amount of money a bank must keep based on its deposits and the reserve ratio.
- Excess reserves
- The amount of reserves a bank has beyond what it is required to hold.
- Money multiplier
- A simplified measure of how much the money supply can increase from new reserves in the banking system.
Common Mistakes to Avoid
- Assuming banks can lend the same deposit repeatedly, which is wrong because each bank must keep required reserves before making a loan.
- Confusing money creation with printing currency, which is wrong because fractional reserve banking mainly creates deposit money through loans and bank accounts.
- Using the reserve ratio as the multiplier, which is wrong because the simple money multiplier is 1 divided by the reserve ratio.
- Ignoring cash withdrawals and banks holding extra reserves, which is wrong because these reduce the actual amount of money multiplication below the simple maximum.
Practice Questions
- 1 A customer deposits $1,000 in a bank and the reserve ratio is 10%. How much must the bank keep as required reserves, and how much can it lend?
- 2 If the reserve ratio is 20% and a new $500 deposit enters the banking system, what is the simple money multiplier and the maximum total increase in deposits?
- 3 Explain why fractional reserve banking can increase the money supply without the government printing new paper money.