Question

The fractional reserve characteristic of the banking system allows banks to create money from bank deposits. Describe briefly why this statement is true using a hypothetical scenario that demonstrates such money creation.

Answer 1

Answer - The money creation process by the commercial banks depends upon the reserve ratio. The lesser reserve ratio , more will be the multiplier and more money will be created. If the full amount will be kept as reserve , the money multiplier will be 1 , and no increase will be there in money supply.

Suppose , initial deposit is $ 1000 and reserve ratio is 10 % ,

Money multiplier = 1/0.10

= 10

Total money created = 1000*10

= $ 10000

But if fractional reserve system is not there , reserve ratio will be 100 %

Multiplier = 1/1.00

= 1

Hence the money supply will only be equal to $ 1000 and decrement of $ 9000 will be seen in money supply.

Hence the fractional reserve system enables the increase in pace of money creation