fractionalreservesystem

The fractional reserve system is a banking practice where banks are required to hold only a fraction of their deposit liabilities in reserve. The remaining portion of the deposits can be loaned out to borrowers. This system allows banks to create money through lending, as the loaned-out funds are often redeposited into other banks, leading to a multiplier effect on the money supply.

The fraction of deposits that banks must hold is determined by reserve requirements set by the central bank. These requirements can vary by jurisdiction and by the type of deposit. For example, demand deposits might have a higher reserve requirement than time deposits. When a bank receives a deposit, it sets aside the required reserve and can lend out the rest. This process repeats as the loaned money is re-deposited, and a portion is again lent out.

Proponents of the fractional reserve system argue that it promotes economic growth by making credit available for investment and consumption. It is seen as a crucial mechanism for facilitating commerce and expanding economic activity. Critics, however, raise concerns about the system's inherent instability, arguing that it can lead to bank runs if too many depositors try to withdraw their funds simultaneously. They also point to the potential for inflation if the money supply expands too rapidly. Central banks play a key role in managing the fractional reserve system through monetary policy tools, such as adjusting reserve requirements and setting interest rates, to influence credit availability and control inflation.