Question

After learning about how money is created, what do you think about the fractional reserve system that we have here in the US and is used around the world? Explain. If you could change something in the fractional reserve system, what would it be? What do you think the impact of this change would be on the macro economy?

Answer 1

Fractional reserve banking is the practice of holding in bank reserves a portion or a fraction of customer deposits and lending out the rest. There is accumulation of cash that would otherwise be unused in bank accounts, and small deposit funds are collected to make loans. In the U.S., the Federal Reserve sets a minimum reserve requirement that must have been set aside by banks. Banks must hold the money as cash in vaults or as deposits with banks of the Federal Reserve. The reserve requirement is currently 10 percent for financial institutions with more than $124.2 million in liabilities. Such banks can, in other words, lend $90 out of every $100 their customers deposit.

Fractional reserve banking works because at the same time people do not usually need access to all of their money. You may have $1,000 in your account, but you are unlikely to withdraw it all. If you do, your withdrawal should be covered by the reserves from other customer accounts. However, things break down if everyone in the system simultaneously withdraws their money. This is often referred to as a "bank run." When customers fear a bank will be in financial trouble, the bank will be flooded with demands for withdrawal. To satisfy the requests, the money is not there, so the bank becomes insolvent. Bank runs are justified in some cases, and they sometimes manifest

One thing is certain: your banking relationship would look different without fractional reserve banking. Instead of paying interest on your deposits, banks may charge you (or much more) for their services. Indeed, by putting your money to work and keeping the difference between what they charge borrowers and what they pay you as the depositor, banks earn revenue.