Question

List and explain two reasons why the fractional reserve system makes it difficult for the Federal Reserve Bank to control the exact size of the money supply. What, if anything, can the Fed do to keep these problems in check?

Answer 1

Fractional reserve banking is a banking mechanism where banks retain just a percentage of the funds held as deposits by their clients. This encourages them to use the majority of it to make loans and thereby raise new capital in essence. This gives commercial banks the ability to control the supply of capital directly. In fact, even though central banks are in charge of regulating the supply of capital, commercial banks produce much of the capital in modern economies by fractional reserve banking.

The fractional reserve banking structure is, at first sight, probably too amazing to be real. How will banks be able to make capital out of thin air? It is important to remember at this stage that they produce capital, not wealth. Money is just a means of trade in this sense. It doesn't have inherent meaning. Borrowers get extra cash by taking on a loan, but they still take on more loans at the same time. So they aren't wealthier than ever at the end of the day. In other words, a rise in the supply of capital just results in higher liquidity ratios, so it does not at all make the economy wealthier.

Fractional reserve banking is a banking mechanism where banks retain just a percentage of the funds held as deposits by their clients. This encourages them to make loans (for example, to purchase a home, a new car, or go to university) to those who want to borrow money. Essentially, this method generates money and therefore increases the supply of money. However, it is important to remember that, while new investment is generated, the economy's total wealth remains unchanged.