What is a fractional reserve banking system? How does it influence the ability of banks to create money?
If a bank must keep all of its deposits as reserves, the money supply is simply the currency in circulation plus the currency deposited in banks. A fractional reserve banking system allows the bank to lend part of its deposits, which leads to the creation of money. Banks therefore can earn more income as they lend more money, and society has a larger money supply with which to conduct transactions. Consider this example: You deposit a $1,000 scholarship check in the bank. If the required reserve ratio is 20 percent, explain how the banking system will create new money and how much money can potentially be created. Once the $1,000 is deposited, the bank is required to hold $200 (20 percent) as required reserves. The remaining $800 represents excess reserves and can be loaned out. The bank may lend the $800 to another customer who may deposit it in another bank, which will then hold 20 percent and lend out the remaining 80 percent again. This process continues until the deposits become t
