Understanding Fractional Reserve Banking

A method known as fractional reserve banking entails banks lending to individuals, organizations, or businesses in need money taken from the savings accounts of depositors. However, banks are only permitted to keep a small portion of the money that depositors have saved aside because depositors have the option to withdraw their funds at any time and banks are not permitted to use all of their depositors’ funds for loans. Since the 19th century, banks have been allowed to consider the money that depositors have saved (money that can be withdrawn immediately), so when a deposit is made, the money or funds no longer belong to depositors. Because it creates a credit expansion, the use of fractional reserve banking causes the money in checking or savings accounts to grow more than it would in a fixed money system. The deposit made through the emergence of loan and cash, also known as the “broad money supply,” differs significantly from the actual paper currency produced by the nation’s central bank due to the predominance of fractional reserve banking. Banks are able to create money thanks to fractional reserve banking, which has a significant impact on the economy. People can borrow money through fractional reserve banking, giving them more money to spend. On the other hand, some economists contend that it is the cause of inflation.

The authenticity of the history of fractional reserve banking is the subject of debate among various viewpoints.


Some historians believe that the introduction of money helped alleviate the difficulties of barter trade. In ancient England, goldsmiths used to get people’s gold coins for safekeeping in exchange for an “I owe you” note that could be used to trade or settle debts. In the end, the I.O.U. notes that were issued as promissory notes turned into money. As time went on the Gold smiths acknowledged they could issue out I.O.U notes to individuals without taking gold coins from them, with the conviction that all stores won’t be guaranteed simultaneously. They could collect from their debtors or sell collateral in exchange for gold in the event that this should occur. This is just a good story to show how the banking system works and that money that hasn’t been used is bad for the economy.

What is the actual procedure for fractional reserve banking?

When money is deposited in a bank, the bank is required to keep a certain percentage, or a fraction of the money, which is then put on reserve at the central bank to protect against deposits. The term “reserve requirement” refers to this percentage. The remainder can be loaned to the general public by the bank. For instance: if you make a deposit of £100,000 in the bank. If the bank has a reserve requirement of 10%, it will have £90,000 left over to lend to customers in need of loans. By crediting your deposits with £100,000 and lending the additional £90,000 to someone else, the bank has converted £100,000 into £190,000. They earn more money by creating credit. Fractional Reserve Banking is the system by which the bank operates.

The Economic Importance of Fractional Reserve Banking

Fractional reserve banking is very important for both the economy and financial institutions. In recent years, banks have become the foundation of every economy. The fractional reserve banking system has aided economic expansion in a number of ways, and the level of excellence with which banks conduct their operations has a significant impact on the economy as a whole. It has had both positive and negative effects on a nation’s economy. To begin, it has a significant impact on an economy’s growth and cash flow. The economy’s banks now have the ability to create money indirectly thanks to the system. Banks make it easier to make capital, which makes more money for the economy. Customers borrow money from banks to invest, start their own businesses, and create additional employment opportunities. A salary will be paid out to the employee at this point. Items will be purchased with the salary. Businesses receive this money once more. We can see that this is like a perpetual cycle, and if the banking system doesn’t exist, there won’t be enough money to go around. The economy plays a crucial role because of the impact that this will have.

Households Benefit from Fractional Reserve Banking

Fractional reserve banking enables households to acquire assets and properties and pay later. Banks can assist individuals in purchasing assets because they can create money with or without deposits. thereby enhancing the comfort of their lives. Banks can offer mortgage loans to homeowners at low interest rates thanks to fractional reserve banking. This would encourage homeowners to borrow money to start a new business, which would benefit the economy. As a result, households and businesses will contribute to the economy with their own money. However, the economy is impacted when banks lend money to households.

The Effect of Fractional Reserve Banking on Inflation

According to some economists, fractional reserve banking aids in the management of inflation. The reserve requirement percentage is established by a country’s central bank. The industry’s amount of money in circulation is determined by the reserve requirement’s level. Simply put, inflation is the pursuit of fewer goods by more money. The banks will have less money to lend to the public if the reserve requirement is increased, which will result in less money in the economy. The rate of inflation will be low at this point. However, when the reserve requirement is reduced, banks will lend more money to the general public, which will raise inflation. Positive or negative inflation is possible.


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1 thought on “Understanding Fractional Reserve Banking

  1. Yamoah Bismark kyei Reply

    Im really glad for leaning about Fractional reserve banking and creation of money in circulation to support the economy

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