Question 1

How does fractional-reserve banking expand the money supply?

Accepted Answer

In fractional-reserve banking, banks keep only a portion of deposits as reserves and lend the rest. When a borrower deposits a loan into another bank, that bank also lends a portion of it. This cycle repeats, multiplying deposits across the banking system. Starting with $100 in currency, deposits can grow to $190 or more as loans circulate through multiple banks.

Question 2

What is the reserve-deposit ratio and how does it work?

Accepted Answer

The reserve-deposit ratio is the percentage of deposits a bank holds as reserves rather than lending out. For example, a 10% reserve-deposit ratio means a bank keeps $10 of every $100 deposited and lends out $90. This ratio determines how much money banks can create through lending and directly affects the total money supply in the economy.

Question 3

Why do banks record deposits as liabilities on their balance sheet?

Accepted Answer

Banks record deposits as liabilities because they owe the full amount to depositors, who can withdraw their money at any time. On the assets side, banks record reserves and loans. Even when a bank lends out part of a deposit, it remains liable for the entire original deposit amount, creating the foundation for fractional-reserve banking.

Question 4

What happens to a loan after a borrower receives it from a bank?

Accepted Answer

After receiving a loan, the borrower typically deposits it into another bank for safekeeping rather than holding the currency. That second bank then records the deposit as a liability, keeps a portion as reserves, and lends out the remainder. This deposit circulation process allows the original monetary base to generate a larger total money supply.

Question 5

How does the monetary base differ from the total money supply?

Accepted Answer

The monetary base is the initial currency created by the central bank. In fractional-reserve banking, this base grows into a larger total money supply through repeated cycles of deposits and lending. For instance, a $100 monetary base can expand to $190 or more as deposits multiply across banks through the lending process.

Question 6

What distinguishes fractional-reserve banking from other banking systems?

Accepted Answer

Fractional-reserve banking allows banks to lend out most deposits while keeping only a fraction as reserves. This contrasts with systems where banks hold 100% of deposits in reserve. The fractional approach enables deposit multiplication and money supply expansion, making it the foundation of modern banking and monetary policy.

Question 7

How does the public's deposit behavior support fractional-reserve banking?

Accepted Answer

Fractional-reserve banking relies on the public depositing currency in banks rather than holding it. When borrowers deposit loans into banks, those deposits become new liabilities that banks can partially lend out again. This continuous circulation of deposits through the banking system enables the multiplication effect that expands the money supply beyond the original monetary base.

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