Question

What is fractional reserve banking? Describe the process by which money is created within the private sector. What does this imply for central banks?

Answer 1

Fractional reserve banking is the method of keeping a part or percentage of deposits from customers in bank reserves and lending out the remainder. Money in bank accounts that would otherwise be idle is exchanged, and funds from small deposits are collected to make loans. In the U.S., the Federal Reserve sets a minimum reserve limit that the banks must have already set aside. The money must be kept by banks as cash in vaults or as deposits with Federal Reserve Banks. The reserve ratio is currently 10 per cent for financial institutions with more than $124.2 million in liabilities. In other words, these banks will lend $90 out of every $100 their clients deposit.

The varying composition of each plan means that the private sector balance sheet would have different consequences. When central bank money is generated to fund investment, the profits of the private sector will naturally increase without raising the amount of debt of the private sector. This is because government spending is increasing the net amount of income for the private sector. Government spending directly raises taxable profits for the private sector; and a tax cut would boost the private sector's disposable income. In doing so, the government increases the net amount of financial assets held by the private sector. The private sector acquired these assets without having to incur any liabilities.