Fractional-Reserve Banking

Fractional-reserve banking is a banking system where banks are required to keep only a fraction of their customers' deposits as reserves, allowing them to lend out the remainder. This system enables banks to create money by lending, thereby increasing the money supply within the economy. While this boosts economic activity, it also creates risks, such as bank runs, if too many customers withdraw their funds simultaneously. Central banks regulate reserve requirements to maintain stability and prevent systemic risks.

Example

A bank receives $1,000 in deposits and, under fractional-reserve banking, keeps $100 as reserves (10%) while lending out $900. This lending process can be repeated, multiplying the impact of the initial deposit on the money supply.