A fractional reserve system is a banking system in which banks hold only a fraction of their depositors’ money on hand. This means that banks can lend out more money than they have in deposits, which allows them to create new money and expand the money supply.
How does a fractional reserve system work?
In a fractional reserve system, banks are required to hold a certain amount of their deposits in reserve. This reserve requirement is set by the central bank and is typically a percentage of deposits. For example, if the reserve requirement is 10%, then banks must hold 10% of their deposits in reserve. The remaining 90% of deposits can be lent out to borrowers.
When a bank lends out money, it creates new money. This is because the loan proceeds are deposited into the borrower’s account, which increases the money supply. The borrower can then use the loan proceeds to purchase goods and services, which further increases the money supply.
The fractional reserve system allows banks to create new money and expand the money supply. This can help to stimulate economic growth and create jobs. However, it can also lead to inflation if the money supply is expanded too quickly.
What are the benefits of a fractional reserve system?
The fractional reserve system has a number of benefits, including:
- Stimulates economic growth by allowing banks to lend out more money than they have in deposits.
- Creates jobs by increasing the money supply and making it easier for businesses to borrow money.
- Provides a buffer against economic shocks by allowing banks to hold reserves in case of a downturn.
What are the risks of a fractional reserve system?
The fractional reserve system also has a number of risks, including:
Inflation if the money supply is expanded too quickly.
- Financial instability if banks lend out too much money and are unable to meet their obligations to depositors.
- Systemic risk if a large number of banks fail at the same time.
How is the fractional reserve system regulated?
The fractional reserve system is regulated by the central bank. The central bank sets the reserve requirement and monitors banks to ensure that they are complying with the rules.
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