4.6 Mechanism of Fractional Reserve Banking

When a bank receives a deposit, it is legally required to keep only a fraction of it (the reserve requirement) in reserve. The remainder can be loaned out to borrowers. This process creates new money in the economy:

Example:

Suppose a bank has a 10% reserve requirement. If someone deposits $100,000 into this bank, the bank must keep $10,000 ($100,000 × 10%) in reserves and can lend out $90,000 ($100,000 - $10,000). The borrower spends the $90,000, which eventually finds its way into another bank as a deposit. This process continues, with each subsequent bank keeping 10% in reserves and lending out the rest. Through this multiplier effect, the initial $100,000 deposit can lead to a total of $271,000 in deposits circulating through the economy.