Fractional Reserve Banking: What It Is and How It Works

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Definition of 'Fractional Reserve Banking: What It Is and How It Works'

Fractional reserve banking is a system in which banks keep only a fraction of their customers' deposits in reserve, and use the rest to make loans. This allows banks to create money out of thin air, which can lead to economic instability.

Here's how fractional reserve banking works:

1. A customer deposits $100 into their bank account.
2. The bank keeps $10 in reserve and lends out the remaining $90.
3. The borrower uses the $90 to buy goods or services from a business.
4. The business deposits the $90 into its bank account.
5. The bank now has $100 in reserves, even though it has only lent out $90.

This process can be repeated over and over again, creating more and more money. In theory, a bank could lend out more money than it has in deposits, as long as it keeps enough reserves to meet its obligations to its depositors.

Fractional reserve banking can be a useful tool for economic growth. By lending out money, banks make it easier for businesses to invest and expand, which creates jobs and stimulates the economy. However, fractional reserve banking can also lead to instability. If too many banks make too many loans, the supply of money can grow too quickly, leading to inflation. And if a bank fails, it can create a chain reaction that can lead to the collapse of other banks and the entire financial system.

In the United States, fractional reserve banking is regulated by the Federal Reserve. The Fed sets reserve requirements, which are the minimum amount of reserves that banks must hold. The Fed also has the power to lend money to banks, which can help to stabilize the financial system.

Fractional reserve banking is a complex system with the potential to create both good and bad outcomes. It is important to understand how fractional reserve banking works so that we can make informed decisions about its regulation.

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