Fractional Reserve Banking

I know I'd normally do a book review for today, but this week I have yet to finish the book I want to write my review on, so I'm going to save it for later.

Instead, today will be a little discussion about fractional reserve banking.

At its essence, fractional reserve banking is a tool that central banks use to determine how drastic changes in monetary policy are. Central banks are constantly changing the supply of money available to the economy through a variety of means.

We won't be covering the methods for the moment, but let us just assume that central banks can do this and that they can do it fairly effectively.

So, when you add money to the economy, what happens to it? Well, it gets circulated around. People buy things with it and, more importantly for the moment, people save it. The biggest assumption of fractional reserve banking is that, eventually, all money eventually ends up in some sort of savings account in a bank.

(The empirical accuracy of this assumption is not one I can attest to, but it should hold up to at least some measure of scrutiny.)

When money is in a bank, it doesn't rest. The bank takes that money and puts it to work. From the bank's point of view, they want to lend all the money they take in from deposits, and always at a higher interest rate then they are giving for savings.

(Again, not exactly true, because the risk of lending money is an important factor. When all loans are considered risky, less money is loaned out then what would be expected.)

However, the bank is not allowed to loan out all of the money they take in. This does two things. The first is obvious, but also important: banks become less likely to fail when they keep a larger portion of what is saved in reserve, rather then lending it out.

The second is less obvious, but also important - the less money the bank can lend out, the less total money there is in the economy.

This occurs because of the cycle of borrowing and lending. When the bank takes in money, they lend it out. That money eventually ends up in a savings account or somesuch at a bank, and is lent out again. This process continues for as long as is possible.

When the federal reserve puts in an amount of money, let's call it M, into the economy, it then undergoes this process. The end result of all of this is that the total money supply of the economy expands by much more then M.

(To be exact, assuming r is the fraction of savings that banks must keep in reserve rather then lending it out, the total increase to the money supply is M*(1/r).)

Changing the ratio, then, causes the impact of monetary policy to increase or decrease as the ratio decreases or increases, respectively. This is why the ratio is hardly ever changed, as opposed to things like the interest rate (which affects how much lending and saving occurs) or market operations (the daily buying and selling of bonds that acts as the finest available manipulator of the money supply available to most central banks).

An important thing to note for the moment is that the majority of banks in America are actually keeping more reserves than they are required to. This phenomenon is a result of the perceived high risk associated with the majority of lending activities at the moment. In short banks, aren't lending, and this makes it harder than normal for the Federal Reserve to impact the economy, for good or for ill.

Anyways. Hopefully that clears up any questions people have on fractional reserve banking and what it is used for. I also kind of skimmed the top of monetary policy, so if people have questions about that or other things, please feel free to ask.

I'll get back to you with the planned book review later this week. Thanks for reading, and I hope you learned something!