Question

What is the role of the fractional reserve banking system in determining the money supply and the money multiplier? How does this role explain the importance of the banking system to a market-based economy and the importance of regulations to ensure the stability of the banking system?

Answer 1

Fractional reserve banking Works by accepting deposits, keeping a portion of it in reserves and then lending out the rest.

This banking type works using money multiplier process, where in the reserve ratio helps in calculating by how much is the money being multiplied.

This banking structure explains how money making process takes place,step by step. It shows how money is lent, in how much proportion the money is lent and how it is multiplied.

This explains the importance of banking system to a market based economy, by creating money.

Regulations in the form of reserve ratio show how this banking structure places importance of keeping a portion of deposits in reserves, for emergency and stability purposes,so that banks do not default in times of panics or bank runs. This ensures stability of the baking system in the economy.