Fractional Reserve Banking
Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties. Many U.S. banks were forced to shut down during the Great Depression because too many people attempted to withdraw assets at the same time.
Fractional Reserve Requirements
Some banks are exempt from holding reserves, but all banks are paid a rate of interest on reserves. This rate is called the "interest rate on reserves" or the "interest rate on excess reserves," the IOR and IOER, respectively. This rate acts as an incentive for banks to keep excess reserves. Banks with less than $15.2 million in assets are not required to hold reserves. Banks with assets of less than $110.2 million but more than $15.2 million have a 3% reserve requirement, and those banks with over $110.2 million in assets have a 10% reserve requirement.
Fractional Reserve Multiplier Effect
The term "fractional reserve" refers to the fraction of deposits held in reserves. For example, if a bank has $500 million in assets, it must hold $50 million, or 10%, in reserves. Analysts reference an equation referred to as the multiplier equation when estimating the impact of the reserve requirement on the economy as a whole. The equation provides an estimate for the amount of money created with the fractional reserve system. The estimate is calculated by multiplying the initial deposit by one divided by the reserve requirement. So, using the example, the calculation is $500 million multiplied by one divided by 10%, or $5 billion. It should be noted that this is not how money is actually created. It is only a way to represent the possible impact of the fractional reserve system on the money supply. As such, while is useful for economics teachers, it is generally regarded as an oversimplification by policymakers.