Fractional reserve banking - The money multiplier

Origin of the Banking System

Prior to the 1800s, savers looking to keep their valuables in safekeeping depositories deposited gold and silver coins at goldsmiths, receiving in turn a note for their deposit . Once these notes became a trusted medium of exchange an early form of paper money was born, in the form.



As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. The goldsmiths change from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional reserve banking was born.



However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.

The Fractional reserve banking

Fractional reserve banking is the banking practice in which a bank lends out most of the funds deposited and keeps the remaining fraction in reserve (as cash and other highly liquid assets), while simultaneously maintaining the obligation to redeem all deposits upon demand. Fractional reserve banking necessarily occurs when banks lend out funds received from deposit accounts, and is practiced by all modern commercial banks.

Repeated bank failures and financial crises led to the creation of central banks – public (government) or privately owned institutions that regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if a bank is low on liquidity. The emergence of central banks mitigated the dangers associated with fractional reserve banking.


Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.

The money multiplier

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.


In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money.


For example, the reserve ratio of 10 % can be expressed as a fraction:


reserve ratio = 1 / 10 = 0.1


So then the money multiplier, will be calculated as follow:


money multiplier = 1 / 0.1 = 10

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to. For instance, in this case, the bank can lend 90 monetary units for each 100 monetary units deposited, while keeping 10 monetary units as a reserve. Only 10% of the deposited money should be kept by the bank, and on lending these 90 monetary units to another bank, the process start over again.

In conclusion

The creation of money out of nothing by banks, allowed by the fractional reserve banking , increases the money supply of a country. According to the quantity theory of money, this larger money supply leads to more money 'chasing' the same amount of goods, which leads to a higher price level. It is the major cause of the inflation (see Inflation - Your money's worst enemy).

Since the amount kept in reserve by the bank is so small compared to the lended amount, the net effect is to artificially expand the money supply far beyond what physically exists. Today, more than 90 percent of the money in circulation is “credit” or money that originated as part of a debt transaction and exists only as numbers associated with an account.

So, what do you think about this? Please, leave your comments.