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Fractional-reserve banking is the banking practice in which only a fraction of a bank's deposits are kept as reserves (cash and other highly liquid assets) available for withdrawal. The bank lends out some or most of the deposited funds, while still allowing all deposits to be withdrawn upon demand. Fractional reserve banking is practiced by all modern commercial banks.

When cash is deposited with a bank, only a fraction is retained as reserves and the remainder can be loaned out (or spent by the bank to buy securities). The money lent or spent in this way is subsequently deposited with another bank, creating new deposits and enabling new lending. The lending, re-depositing and re-lending of funds expands the money supply (cash and demand deposits) of a country. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank. This multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators, and by the excess reserves kept by commercial banks.

Central banks generally require commercial banks to keep a minimum fraction of their customers on demand deposits as reserves (cash and deposits at the central bank). These reserve requirements help limit the amount of money creation that occurs in the commercial banking system, and help to ensure that banks are able to provide enough ready cash to meet normal demand for withdrawals. Problems can arise, however, when depositors seek withdrawal of a large proportion of deposits at the same time; this can cause a bank run or, when problems are extreme and widespread, a systemic crisis. To mitigate these problems, central banks (or other government institutions) generally regulate and oversee commercial banks, act as lender of last resort to commercial banks, and also insure the deposits of the commercial banks' customers.

History

Savers looking to keep their valuables in safekeeping depositories deposited gold coins and silver coins at goldsmiths, receiving in turn a note for their deposit (see Bank of Amsterdam). Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of the goldsmiths' notes.

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. A process was started that altered the role of the goldsmiths 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 redeem (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.

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

Reason for existence

Fractional reserve banking allows people to invest their money, without losing the ability to use it on demand. Since most people do not need to use all their money all the time, banks lend out that money, to generate profit for themselves. Thus, banks can act as financial intermediaries — facilitating the investment of savers' funds. Full reserve banking, on the other hand, does not allow any money in such demand deposits to be invested (since all of the money would be locked up in reserves) and less liquid investments (such as stocks, bonds and time deposits) lock up a lenders money for a time, making it unavailable for the lender to use.

According to mainstream economic theory, regulated fractional-reserve banking also benefits the economy by providing regulators with powerful tools for manipulating the money supply and interest rates, which many see as essential to a healthy economy.

Member banks which fall under the umbrella of central bank regulation have different bankruptcy regulation than a typical business. For this reason the demand deposits of most banks will retain their value in spite of circumstances which would otherwise jeopardize their credit-worthiness.

How it works

The nature of modern banking is such that the cash reserves at the bank available to repay demand deposits need only be a fraction of the demand deposits owed to depositors. In most legal systems, a demand deposit at a bank (e.g. a checking or savings account) is considered a loan to the bank (instead of a bailment) repayable on demand, that the bank can use to finance its investments in loans and interest bearing securities. Banks make a profit based on the difference between the interest they charge on the loans they make, and the interest they pay to their depositors. Since a bank lends out most of the money deposited, keeping only a fraction of the total as reserves, it necessarily has less money than the account balances of its depositors.

The main reason customers deposit funds at a bank is to store savings in the form of a demand claim on the bank. Depositors still have a claim to full repayment of their funds on demand even though most of the funds have already been invested by the bank in interest bearing loans and securities. Holders of demand deposits can withdraw all of their deposits at any time. If all the depositors of a bank did so at the same time a bank run would occur, and the bank would likely collapse. Due to the practice of central banking, this is a rare event today, as central banks usually guarantee the deposits at commercial banks, and act as lender of last resort when there is a run on a bank. However, there have been some recent bank runs: the Northern Rock crisis of 2007 in the United Kingdom is an example. The collapse of Washington Mutual bank in September 2008, the largest bank failure in history, was preceded by a "silent run" on the bank, where depositors removed vast sums of money from the bank through electronic transfer. However, in these cases, the banks proved to have been insolvent at the time of the run. Thus, these bank runs merely precipitated failures that were inevitable in any case.

In the absence of crises that trigger bank runs, fractional-reserve banking usually functions smoothly because at any one time relatively few depositors will make cash withdrawals simultaneously compared to the total amount on deposit, and a cash reserve can be maintained as a buffer to deal with the normal cash demands from depositors seeking withdrawals. In addition, in a normal economic environment, cash is steadily being introduced into the economy by the central bank, and new funds are steadily being deposited into the commercial banks.

However, if a bank is experiencing a financial crisis, and net redemption demands are unusually large over a period of time, the bank will run low on cash reserves and will be forced to raise additional funds to avoid running out of reserves and defaulting on its obligations. A bank can raise funds from additional borrowings (e.g. by borrowing from the money market or using lines of credit held with other banks), or by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of cash or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining cash reserves before they do, triggering a cascading crisis that can result in a full-scale bank run.

Money creation

Modern central banking allows multiple banks to practice fractional reserve banking with inter-bank business transactions without risking bankruptcy. The process of fractional-reserve banking has a cumulative effect of money creation by banks, essentially expanding the money supply of the economy.

There are two types of money in a fractional-reserve banking system operating with a central bank:

1. central bank money (money created or adopted by the central bank regardless of its form (precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money))
2. commercial bank money (demand deposits in the commercial banking system) - sometimes referred to as chequebook money

When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of m1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank's reserves, the m1 money supply expands by the size of the loan. This process is called deposit multiplication.

Example of deposit multiplication

The table below displays how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times with a fractional-reserve rate of 20% to ultimately create $400 of commercial bank money. Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands.

The process begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as reserves, and then loans out the remaining 80 percent, or $80. At this point, the money supply actually totals $180, not $100, because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.). These claims by depositors on banks are termed demand deposits or commercial bank money and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial money is equivalent to central bank money – it is impossible to tell the two forms of money apart unless a bank run occurs (at which time everyone wants central bank money).

At this point, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum increase in the money supply is $400.

For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. Deposits will always be equal to loans plus a bank's reserves, since loans and reserves are created from deposits. This is the basis for a bank's balance sheet.

Fractional reserve banking allows the money supply to expand or contract. Generally the expansion or contraction of the money supply is dictated by the balance between the rate of new loans being created and the rate of existing loans being repaid or defaulted on. The balance between these two rates can be influenced to some degree by actions of the central bank.

This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money. The value of commercial bank money is based on the fact that it can be exchanged freely at a bank for central bank money.

The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process. 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.

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.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R:

${\displaystyle m={\frac {1}{R}}}$

Example

For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:

${\displaystyle R={\tfrac {1}{5}}}$

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

${\displaystyle m={\frac {1}{1/5}}=5}$

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.

The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold—usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States. In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.

Confusingly there are many different "money multipliers", some referring to ratios of rates of change of different money measures and others referring to ratios of absolute values of money measures.

Reserve requirements

The reserve requirements are intended to prevent banks from:

1. generating too much money by making too many loans against the narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although the reserve is a legal minimum, it is understood that in a crisis or bank run, reserves may be made available on a temporary basis).

In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, the capital requirement ratio acts to prevent an infinite amount of bank lending.

Alternative views

Seth B. Carpenter and Selva Demiralp have written of their skepticism of the money multiplier mechanism.

Also, the idea that the reserve requirement places an upper limit on the money supply is disputed by some economists outside of the mainstream. Notably, theories of endogenous money date to the 19th century, and were subscribed to by Joseph Schumpeter, and later the post-Keynesians. Endogenous money theories postulate that the supply of money is credit-driven and determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities.

Money supplies around the world

Fractional-reserve banking determines the relationship between the amount of central bank money (currency) in the official money supply statistics and the total money supply. Most of the money in these systems is commercial bank money. Fractional reserve banking involves the issuance and creation of commercial bank money, which increases the money supply through the deposit creation multiplier. The issue of money through the banking system is a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

Regulation

Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.

Central banks

Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.

Liquidity and capital management for a bank

To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:

1. Selling or redeeming other assets, or securitization of illiquid assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity),
4. Issuing additional capital instruments, or
5. Reducing dividends.

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, a situation known as a run on the bank.

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.

Risk and prudential regulation

In a fractional-reserve banking system, in the event of a bank run, the demand depositors and note holders would attempt to withdraw more money than the bank has in reserves, causing the bank to suffer a liquidity crisis and, ultimately, to perhaps default. In the event of a default, the bank would need to liquidate assets and the creditors of the bank would suffer a loss if the proceeds were insufficient to pay its liabilities. Since public deposits are payable on demand, liquidation may require selling assets quickly and potentially in large enough quantities to affect the price of those assets. An otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand).

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason, fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders).

Many governments have enforced or established deposit insurance systems in order to protect depositors from the event of bank defaults and to help maintain public confidence in the fractional-reserve system.

Responses to the problem of financial risk described above include:

1. Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below);
2. Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors, creditors and shareholders should result in effective risk management; and,
3. Withdrawal restrictions: some bank accounts may place a limit on daily cash withdrawals and may require a notice period for very large withdrawals. Banking laws in some countries may allow restrictions to be placed on withdrawals under certain circumstances, although these restrictions may rarely, if ever, be used;
4. Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved.

Example of a bank balance sheet and financial ratios

An example of fractional reserve banking, and the calculation of the reserve ratio is shown in the balance sheet below:

In this example the cash reserves held by the bank is $3010m ($201m currency + $2809m held at central bank) and the demand liabilities of the bank are $25482m, for a cash reserve ratio of 11.81%.

Other financial ratios

The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc.

For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:

1. The cash reserve ratio is $3010m/$25482m, i.e. 11.81%.
2. The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%.
3. The equity capital ratio is $8703m/107787m, i.e. 8.07%.
4. The tangible equity ratio is ($8703m-$3297m)/107787m, i.e. 5.02%
5. The total capital ratio is ($8703m+$2062m)/$107787m, i.e. 9.99%.

It is very important how the term 'reserves' is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

How the example bank manages its liquidity

The ANZ National Bank Limited explains its methods as:

Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements.

The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour.

Criticism

The primary criticisms relate to the potential fragility of bank liquidity in a fractional reserve banking environment, the financial risk of bank runs that depositors bear when depositing money with banks, and the impact that demand deposits have on the stock of money, and on inflation (that is, the implicit expansion of the money supply and its associated impact on prices and the exchange rate). An alternative to fractional reserve banking is full-reserve banking. With full-reserve banking, some monetary reformers, such as Stephen Zarlenga of the American Monetary Institute, support the concurrent issuance of debt-free fiat currency from the Treasury, while others such as Congressman Ron Paul and the Ludwig von Mises Institute call for a commodity currency as existed under the gold standard.

Exacerbation of the business cycle

Adherents of the non-mainstream Austrian School claim that fractional-reserve banking, by expanding the money supply, will lower the interest rates compared to a hypothetical full-reserve banking system, although this idea has been criticized within mainstream economics. Austrian adherents argue that the presumed discrepancy will affect the role of the interest rate as the price of investment capital, guiding investment decisions. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, shared in the Nobel Memorial Prize in Economic Sciences for 1974. Hayek accepted that bank credit and fractional reserve banking — even if they contributed to business cycles — were necessary as "the price we pay for a speed of development exceeding" that which would otherwise be possible, and that "financial institutions have never been prohibited from holding fractional reserves."

A few Austrian School economists, such as Pascal Salin, also suggest that a full-reserve banking system should not be enforced legally, and dispute Murray Rothbard's characterization of fractional-reserve banking as a simple form of recursive embezzlement, and rather advocate the abolition of central banking, and suggest that free banking replace the current system. Austrian monetary theorist George Selgin has also argued in favor of fractional reserve banking.

Effects of an increased money supply

Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply. 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. Austrian economists state that this expansion of the broad money supply (demand deposits and notes) caused by fractional reserve banking is a cause of price inflation.

See also

• Islamic banking
• Narrow banking
• Open Market Operations
• Seignorage
• Usury

References

1. The Bank Credit Analysis Handbook: A Guide for Analysts, Bankers and Investors by Jonathan Golin. Publisher: John Wiley & Sons (August 10, 2001). ISBN 0471842176 ISBN 978-0471842170
2. Bankintroductions.com - Economic Definitions
3. Investopedia economic definitions
4. investorwords economic definitions
5. Abel, Andrew; Bernanke, Ben (2005), "14.1", Macroeconomics (5th ed.), Pearson, pp. 522–532
6. ^ Mankiw, N. Gregory (2002), "Chapter 18: Money Supply and Money Demand", Macroeconomics (5th ed.), Worth, pp. 482–489
7. "Modern Money Mechanics. Page 37. Money Creation and Reserve Management" (PDF). Federal Reserve Bank of Chicago.
8. "Reserve Maintenance Manual" (PDF). Federal Reserve.
9. ^ United States. Congress. House. Banking and Currency Committee. (1964). Money facts; 169 questions and answers on money- a supplement to A Primer on Money, with index, Subcommittee on Domestic Finance ... 1964. Washington D.C.{{cite book}}: CS1 maint: location missing publisher (link)
10. ^ The Federal Reserve in Plain English - An easy-to-read guide to the structure and functions of the Federal Reserve System. See page 5 of the document for the purposes and functions: http://www.frbsf.org/publications/education/plainenglish/index.html
11. Abel, Andrew; Bernanke, Ben (2005), "7", Macroeconomics (5th ed.), Pearson, pp. 266–269
12. Mankiw, N. Gregory (2002), "9", Macroeconomics (5th ed.), Worth, pp. 238–255
13. Committee on Finance and Industry 1931 (Macmillan Report) on bankers desire to complicate banking issues."The economic experts have evolved a highly technical vocabulary of their own and in their zeal for precision are distrustful, if not derisive of any attempts to popularize their science."
14. Page 57 of 'The FED today', a publication on an educational site affiliated with the Federal Reserve Bank of Kansas City, designed to educate people on the history and purpose of the United States Federal Reserve system. The FED today Lesson 6
15. ^ Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:

    "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."

16. ^ European Central Bank - Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money:

    "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via cheques and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"

17. Macmillan report 1931 account of how fractional banking works http://books.google.ca/books?hl=en&id=EkUTaZofJYEC&dq=British+Parliamentary+reports+on+international+finance&printsec=frontcover&source=web&ots=kHxssmPNow&sig=UyopnsiJSHwk152davCIyQAMVdw&sa=X&oi=book_result&resnum=1&ct=result#PPA34,M1
18. Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm

    the reference is found in the "Money Manager" section:

    "the Fed works to control money at its source by affecting the ability of financial institutions to "create" chequebook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."

19. Table created with the OpenOffice.org Calc spreadsheet program using data and information from the references listed.
20. Federal Reserve Education - How does the Fed Create Money? http://www.federalreserveeducation.org/fed101_html/policy/money_print.htm

    See the link to "The Principle of Multiple Deposit Creation" pdf document towards bottom of page.

21. An explanation of how it works from the New York Regional Reserve Bank of the US Federal Reserve system. Scroll down to the "Reserve Requirements and Money Creation" section. Here is what it says:

    "Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

    In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States"

    The link to this page is: http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html
22. http://books.google.com/books?id=I-49pxHxMh8C&pg=PA303&dq=deposit+reserves&lr=&sig=hMQtESrWP6IBRYiiaZgKwIoDWVk#PPA295,M1 William MacEachern, Macroeconomics: A Contemporary Introduction, p. 295
23. ebook: The Federal Reserve - Purposes and Functions:http://www.federalreserve.gov/pf/pf.htm

    see pages 13 and 14 of the pdf version for information on government regulations and supervision over banks

24. http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html
25. http://www.federalreserve.gov/releases/h3/Current/ Federal Reserve Board, "AGGREGATE RESERVES OF DEPOSITORY INSTITUTIONS AND THE MONETARY BASE" (Updated weekly).
26. http://books.google.com/books?id=FdrbugYfKNwC&pg=PA169&lpg=PA169&dq=united+states+money+multiplier&source=web&ots=C_Hw1u82xe&sig=m7g0bMz167DijFsOCbn5f4aWAOU#PPA170,M1 Bruce Champ & Scott Freeman, Modeling Monetary Economies, p. 170 (Figure 9.1).
27. http://www.federalreserve.gov/pubs/feds/2010/201041/index.html Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?
28. http://college.holycross.edu/RePEc/eej/Archive/Volume18/V18N3P305_314.pdf Understanding the Remarkable Survival of Multiplier Models of Money Stock Determination. Eastern Economic Journal, 1992, vol. 18, issue 3, pages 305-314
29. A handbook of alternative monetary economics, by Philip Arestis, Malcolm C. Sawyer, p. 53
30. Reserve Bank of India - Report on Currency and Finance 2004-05 (See page 71 of the full report or just download the section Functional Evolution of Central Banking): http://www.rbi.org.in/scripts/AnnualPublications.aspx?head=Report%20on%20Currency%20and%20Finance&fromdate=03/17/06&todate=03/19/06

    The monopoly power to issue currency is delegated to a central bank in full or sometimes in part. The practice regarding the currency issue is governed more by convention than by any particular theory. It is well known that the basic concept of currency evolved in order to facilitate exchange. The primitive currency note was in reality a promissory note to pay back to its bearer the original precious metals. With greater acceptability of these promissory notes, these began to move across the country and the banks that issued the promissory notes soon learnt that they could issue more receipts than the gold reserves held by them. This led to the evolution of the fractional reserve system. It also led to repeated bank failures and brought forth the need to have an independent authority to act as lender-of-the-last-resort. Even after the emergence of central banks, the concerned governments continued to decide asset backing for issue of coins and notes. The asset backing took various forms including gold coins, bullion, foreign exchange reserves and foreign securities. With the emergence of a fractional reserve system, this reserve backing (gold, currency assets, etc.) came down to a fraction of total currency put in circulation.

31. Murray Rothbard, The Mystery of Banking
32. Stephen A. Zarlenga, The Lost Science of Money AMI (2002)
33. Paper Money and Tyranny, Ron Paul
34. Fiat Paper Money, Ron Paul.
35. Sraffa P. (1932a), Dr. Hayek on Money and Capital, in "Economic Journal", n. 42, pp. 42-53
36. Nicholas Kaldor (1939). "Capital Intensity and the Trade Cycle". Economica. 6 (21): 40–66. doi:10.2307/2549077.
37. Friedman, Milton. "The 'Plucking Model' of Business Fluctuations Revisited". Economic Inquiry: 171–177.
38. The Prize in Economics 1974 - Press Release
39. http://mises.org/journals/rae/pdf/RAE9_1_3.pdf Walter Block and Kenneth A. Garschina, "Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process", Review of Austrian Economics, 1996.
40. Slivinski, Stephen. "Interview: George Selgin". The Federal Reserve Bank of Richmond. Retrieved 2009-10-29.
41. Charles T. Hatch, Inflationary Deception
42. Ludwig von Mises, The Theory of Money and Credit, ISBN 0-913966-70-3 See also: Jesus Huerta de Soto, Money, Bank Credit, and Economic Cycles, ISBN 0-945466-39-4

Further reading

• Crick, W.F. (1927), The genesis of bank deposits, Economica, vol 7, 1927, pp 191–202.
• Friedman, Milton (1960), A Program for Monetary Stability, New York, Fordham University Press.
• Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
• Philips, C.A. (1921), Bank Credit, New York, Macmillan, chapters 1-4, 1921,
• Thomson, P. (1956), Variations on a theme by Philips, American Economic Review vol 46, December 1956, pp. 965–970.
• Federalreserveeducation.org - The Principle of Multiple Deposit Creation
• Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
• Bank for International Settlements - The Role of Central Bank Money in Payment Systems

External links

• Narrow banking
• Modern Money Mechanics Federal Reserve educational material explaining how money is created. This document from 1992 does not reflect more recent accords on the limits of money creation.

• Banking
• Money
• Monetary policy
• Economic policy
• Central banks