1. Basic Principle: In a fractional reserve banking system, banks are required to hold only a portion of their customers' deposits as reserves. This reserve ratio is set by the central bank, and the remaining funds can be used for various financial activities, including loans and investments.
2. Reserve Ratio: The reserve ratio is the percentage of deposits that banks must keep as reserves. For example, with a 10% reserve ratio, a bank can lend out 90% of its deposits while keeping the other 10% as reserves.
3. Money Creation: When a bank receives a deposit, it keeps a fraction of it as reserves and lends out the rest. The borrower, in turn, might deposit the borrowed funds into another bank, which will also keep a fraction as reserves and lend out the remainder. This process continues, effectively creating new money in the economy.
4. Money Multiplier Effect: The fractional reserve banking system allows for a money multiplier effect. The total money supply can be significantly larger than the initial amount deposited due to the creation of new loans and subsequent deposits in the system.
5. Risks and Stability: While fractional reserve banking fosters economic growth through increased lending and investment, it also comes with risks. If too many depositors try to withdraw their funds simultaneously (a bank run), the bank may not have enough reserves to meet the demand, leading to potential instability.
6. Regulation: Central banks play a crucial role in regulating fractional reserve banking. They set the reserve requirements, conduct open market operations, and act as a lender of last resort to maintain stability in the banking system.
7. Criticism: Fractional reserve banking has been criticized for its potential to exacerbate economic cycles, contribute to inflation, and create financial instability. Additionally, the expansion of the money supply might not always align with real economic growth, leading to various economic challenges.
8. Alternatives: Some economists propose alternative banking systems, such as full reserve banking or Islamic banking, which have different approaches to handling deposits and lending.
In conclusion, fractional reserve banking is a fundamental aspect of modern banking systems, allowing banks to create money through lending while balancing the need for liquidity and stability. However, it also comes with inherent risks and complexities that require careful regulation and oversight to ensure the stability of the financial system.
