Introduction to Economics Part 8 - The Fractional Reserve System

The fractional reserve banking system is the system the banks of the United States have used since the National Banking Act of 1862.  It affects every single one of us every day, which is why I'm talking about it here.

What happens to your money when you deposit it in a bank?

Let's say you have $1,000, and you deposit your $1,000 in a savings account.  To illustrate how the bank views your $1,000, let's use an old-fashioned method of accounting called the T Chart.

When you deposit $1,000, the bank now has an extra $1,000 in its reserves, so the amount gets added to the assets column.  However, since you can withdraw your $1,000 at any time, it also serves as a liability, and is added to the liability column.  The net balance is $0, which makes sense, since it is your money, not the bank's.  This means...

LIABILITIES ALWAYS EQUAL ASSETS

So now the bank has possession of your $1,000.  What happens next?  Well, in order to make a profit, the bank will loan your $1,000 out to borrowers and charge interest.  How much will they lend out?  The Federal Reserve sets a quantity known as the reserve requirement.  This is the minimum percentage of deposited funds a bank must keep in its reserves.  If the reserve requirement is 100%, then the system is called full reserve banking.  This means that the banks have enough money in reserve to give to all of their depositors, even if they all come at the same time.  This is not what happens.

The reserve requirement is less than 100%, so we have what's called a fractional reserve banking system.  This means that a bank only has to keep a certain percentage of deposits in reserve, and can loan the rest out.

A typical requirement of the Federal Reserve is 10%.  This means that each bank must keep 10% of the money deposited in their reserves, while 90% of it can be loaned out.  They can keep more, but not less.  The Federal Reserve constantly audits its member banks to make certain they do not fall below the reserve requirement.

For our purposes, we will assume that the reserve requirement is 10%, and that all banks loan out the maximum amount of money they can.

So, out of your $1,000, they will keep $100 and loan out $900.  They still have $1,000 in the liabilities column.  In the assets column, they have the $100 in reserve, and $900 in loans, since from the bank's perspective, a loan is an asset.  The values on both sides of the chart are equal, as they always should be.

This is where it gets a little tricky.

The $900 gets loaned to someone, and that someone uses that $900 to pay for whatever he wanted the loan for.  Whomever he pays deposits that money in their bank account.  It could be the same bank, or a different bank.  Either way, it's a new deposit in the banking system.


When this $900 is deposited, the bank gets another $900 in reserves and another $900 in liabilities, since the new depositor can withdraw this money at any time.  Both sides of our T Chart have $1,900, not just the original $1,000.  $900 have been created out of nothing.  If both of these depositors demanded their money, the bank would have to pay them $1,900, but the bank only has $1,000 in reserves.  This is a serious problem.  The bank cannot meet the demands of both depositors.  This is what is called a bank run.

In order to pay back its depositors, the bank must borrow money from other banks.  If other banks are unwilling or unable, the Federal Reserve was established to be the lender of last resort.

$900 has been created out of nothing, but this is transparent to the bankers.  If you ask them if they're creating money, they will say no - they are merely loaning part of what has been deposited.  But we can keep going with this process to create even more money.  Keeping 10% in reserve and loaning the rest, the numbers work out like this.

Notice how the quantity gets smaller each time.  Sooner or later it will disappear.  Notice also, however, that the overall total liabilities continues to increase, while in reality the bank still only has $1,000.

When this has all worked out, the number in the liabilities column will have multiplied by a factor of one over the reserve rate.

1 / RR

In our case, with a 10% reserve ratio, the money multiplier will be X10.  Our original $1,000 will turn into $10,000 by the time this is all done.

If the government runs a $100 Billion deficit (tiny by today's standards), the treasury sells bonds to the Federal Reserve, and the Federal Reserve increases the amount of money in the treasury's account by $100 Billion.  Once it goes through the banking system, $900 Billion dollars will have been created out of thin air.  All $900 Billion contribute to inflation and ultimately take the value from paychecks and savings accounts by increasing prices in stores and for services.

Wealth Taken:

$3,278 for each man, woman, and child.
$4,591 for each adult.
$8,928 per household.

This allows the government and the banks to spend beyond their means.  Since they are the first ones to spend the money, they can purchase at the full power of the dollar.  By the time it trickles down to everyday people, it has lost nearly all of its value to inflation.

This is why inflation is a tax, and an extremely regressive one.  The fractional reserve system benefits the government and the rich at the expense of the poor and middle class.

Thanks for reading!