Banks not only deposit your money. They also create new money to circulate in the economy through a system called Fractional Reserve Banking. Using this system banks keep only a fraction of their deposits as reserves and lend out the rest. This way banks can create new money when they make loans, but they also face the risk of running out of money if too many customers withdraw their deposits at the same time.
Suppose there is a bank that has $1000 in deposits from one of its customers. The bank has to keep 10% of its deposits as reserves. This is called Reserve Ratio. In this case a $100 should be kept as a reserve. The bank can lend out the remaining 90%, which is $900, to other customers who need money. The bank charges interest on its loans, which is how it makes money. They lend at 6% for example, and keep deposits at 1%. The difference which is 5% is the bank's profit.
Now, let's say that the bank lends $900 to Alice, who wants to buy a new car. The bank simply increases Alice's account balance by $900. Alice can then use this money to buy her car from Bob, who sells cars.
Bob will deposit this money in his own bank account, which will increase his balance by $900. Bob's bank will then lend out some of this money to another customer. It lends $810, and keep 10% as reserves, so $90. The second customer will use this money to buy something else from another seller, who will deposit it in another bank account, and so on.
In this way, the original $1000 deposit can create more than $1000 of new money in the economy. How much more? Well, that depends on how much each bank keeps as reserves and how much it lends out. The lower the reserve ratio (the percentage of deposits that banks keep as reserves), the higher the money multiplier (the ratio of new money created to the initial deposit).
For example, if the reserve ratio is 10%, then the money multiplier is 10. This means that a $1000 deposit can create up to $10,000 of new money in the economy. If the reserve ratio is 20%, then the money multiplier is 5. This means that a $1000 deposit can create up to $5000 of new money in the economy.
Of course, these are just theoretical numbers. In reality, there are many factors that affect how much new money banks can create, such as:
- The demand for loans:
Banks can only create new money if there are people who want to borrow money from them.
- The supply of deposits:
Banks can only lend out money if there are people who want to save money with them.
- The regulation of banks:
Banks have to follow certain rules and regulations that limit how much they can lend out and how much they have to keep as reserves.
- The behavior of banks:
Banks have to be careful and prudent when they make loans, because they have to make sure that they can get their money back from their borrowers.
- The behavior of customers:
Customers have to be responsible and honest when they borrow money from banks, because they have to pay back their loans with interest.
So, as you can see, fractional reserve banking is a system where banks create new money when they make loans, but they also face some risks and challenges when they do it. Banks play a very important role in the economy by providing credit and liquidity to individuals and businesses. However, banks also need to be monitored and regulated by the government and the central bank to ensure that they do not create too much or too little money for the economy.
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