Fractional reserve banking system

Fractional reserve banking system

The fractional reserve banking system is a system where banks
only hold a fraction of their deposits as reserves (R). These reserves
are kept in the banks’ vaults and as deposits with the central bank.
The function of these reserves is to back individual and business
deposits at the bank. What determines how much of their deposits
banks keep as reserves? This reserve-deposit ratio (re) depends on
the required reserve ratio that is set by the Central Bank. The
required reserve ratio determines the minimum amount of reserves
banks have to hold by law. The remaining deposits called the excess
reserves can be used for making loans.

Under the fractional reserve banking system, banks are able to create money when they make loans as in the process of lending new deposits (D) are created. Assuming that banks lend out all their excess reserves and that the public deposits whatever loan amount they receive.