Understanding Fractional Reserve Banking

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Monetary expansion is a term associated with the relationship between the increase in monetary reserves held by the central bank, and the money supply. In the domain of fractional reserve banking the banks hold on only to a fraction of the reserve deposits in their coffers, and loan out the rest.

Most commercial banks operating under fractional reserve systems risk turning insolvency in the event of a simultaneous withdrawal of funds. This risk is compensated by using the lender of last resort (central bank), however this also creates more financial obligations for the institution.

Fractional reserve banking takes place as financial institutions loan some of the money obtained through client deposits. A commercial bank creates money the moment it enters into a loan agreement with a borrower. The bank then credits the account of the borrower a certain sum of money in exchange, since a debt equals the monetization of assets.

The main business of fractional reserve banking is the creation of money, while circumventing intermediation. While the central bank usually receives hundred percent of their deposits, and the fractional reserve banking normally pays interest, resembling more in this aspect, an investment bank.

Credit institutions are allowed by the monetary authorities to issue credits until they have sufficient stocks in their possession (reserves), whose level is determined by the monetary authorities. The monetary authorities can use this level as a tool to slow down the increasing investment.

However, this tool is rarely used in developed countries, where central banks employ interest rates rather than regulate investment, and the minimum rate of compulsory reserves vary little.

The key to defining fractional reserve lies in the irregular deposit contract involving accounts held. It is important to distinguish the deposits where the depositor gives temporary access to money in exchange for payment of the deposit accounts in which the depositor has full rights of their funds.

The credit multiplier is the efficient measuring of extra credit in the economy resulting from an increase in reserve bank funds. The central bank relates to the currency it issues, and credit balances of private financial institutions.

The multiplier effect of credit revolves around money creation as it goes on to feed an increase in the monetary base of the central bank. The multiplier effect is in practice estimated between 1 and 3 for M1, and higher values for M2 and M3. The multiplier may change as the demand for money persists, causing a tightening of credit (otherwise known as the credit crunch), which justifies higher emissions by monetary authorities to maintain the quantity of money.

 

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