Fractional Reserve Banking

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In the United States banks operate under the fractional reserve system. This means that the law requires banks to keep a percentage of their deposits as reserves in the form of vault cash or as deposits with the nearest Federal Reserve Bank. They loaned out the rest of their deposits to earn interest. Such banking practices formed the basis for the banking system's ability to "create" money.

To illustrate the creation of money, suppose an individual deposited one thousand dollars in a bank and the reserve requirement is 20 percent. The bank was required to keep $200 on reserve but could loan out $800. The $800 loan paid for a television and was deposited in another bank, which, in turn, kept 20 percent but loaned out $640 to someone else. At that point, $1440 had been created and used for purchases.

The Federal Reserve System affects the nation's money supply directly by adjusting the amount of reserves it requires member banks to keep. If a 15 percent reserve requirement was lowered to 10 percent, more money was available to businesses and individuals for loans. The money supply could increase. In contrast, if the reserve requirement was raised to 30 percent, less money could be loaned, and the money supply shrank.

The first banks in the United States were chartered by the states and were not required to keep reserves. By 1820 a few New York and New England banks entered into redemption arrangements provided that a sufficient deposit of gold was maintained in their respective vaults to guarantee their paper money. In essence these gold deposits represented the first required reserves. Most states still had no reserve requirement when the American Civil War (18611865) began in 1861. In 1863 the National Bank Act established reserve requirements to ensure liquidity, the ability to satisfy a customer's cash demands, especially during times of financial panic. A series of bank runs in the late nineteenth and early twentieth centuries demonstrated that reserve requirements helped little in providing liquidity. The Federal Reserve System created in 1913 became the lender of last resort, capable of meeting cash needs. The notion of reserves meeting liquidity demands all but vanished. Instead reserve requirements evolved into a monetary policy tool of the Federal Reserve System for controlling the nation's money supply and credit conditions.

See also: Federal Reserve System, Federal Reserve Banking Act