Fractional-Reserve Banking I

Imagine an economy where the central bank has created $100 in currency, which we call the monetary base. Let's see how it can lead to a larger total money supply. The public is assumed to deposit all the currency in banks.

Assume that each bank holds ten percent of its deposits as reserves and lends the rest. The reserve–deposit ratio is 10%.

The public deposits $100 in Bank A. The bank keeps $10 as reserves and lends out $90 of new loans. Bank A has $100 in deposits as liabilities, and its assets include $10 in reserves and a $90 loan. Though $90 is lent out, the full $100 deposit remains on the bank’s books as a liability.

The recipient of that $90 bank loan does not hold onto the currency. As they prepare to use the loan to make a future purchase, they deposit it into Bank B. So, the total money supply is $190: $100 in deposits in Bank A and $90 in deposits in Bank B.

This system, in which banks keep only some of their deposits on reserve, is called fractional-reserve banking.