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“Fractional-reserve banking enables banks to make loans that are a multiple of their reserves, and as...

“Fractional-reserve banking enables banks to make loans that are a multiple of their reserves, and as a consequence the money supply grows.” True or false? Explain your answer.

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Answer #1

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Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. This is done to theoretically expand the economy by freeing capital for lending.

Fractional reserve refers to the fraction of deposits held in reserves. For example, if a bank has $100 million in assets, it must hold $10 million, or 10%, in reserve. With the help of multiplier equation we can estimate the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. So, here we get $100 million multiplied by one divided by 10% which is $1 billion.

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