Docstoc

Role of fractional reserve banking

Document Sample
Role of fractional reserve banking Powered By Docstoc
					Monetary expansion is a term associated with the relationship between the increase in
monetary reserves held by the central bank, and the money supply. In the domain of fractional
reserve banking the banks hold on only to a fraction of the reserve deposits in their coffers, and
loan out the rest.

Most commercial banks operating under fractional reserve systems risk turning insolvency in the
event of a simultaneous withdrawal of funds. This risk is compensated by using the lender of
last resort (central bank), however this also creates more financial obligations for the institution.

Fractional reserve banking takes place as financial institutions loan some of the money obtained
through client deposits. A commercial bank creates money the moment it enters into a loan
agreement with a borrower. The bank then credits the account of the borrower a certain sum of
money in exchange, since a debt equals the monetization of assets.

The main business of fractional reserve banking is the creation of money, while circumventing
intermediation. While the central bank usually receives hundred percent of their deposits, and
the fractional reserve banking normally pays interest, resembling more in this aspect, an
investment bank.

Credit institutions are allowed by the monetary authorities to issue credits until they have
sufficient stocks in their possession (reserves), whose level is determined by the monetary
authorities. The monetary authorities can use this level as a tool to slow down the increasing
investment.

However, this tool is rarely used in developed countries, where central banks employ interest
rates rather than regulate investment, and the minimum rate of compulsory reserves vary little.

The key to defining fractional reserve lies in the irregular deposit contract involving accounts
held. It is important to distinguish the deposits where the depositor gives temporary access to
money in exchange for payment of the deposit accounts in which the depositor has full rights of
their funds.

The credit multiplier is the efficient measuring of extra credit in the economy resulting from an
increase in reserve bank funds. The central bank relates to the currency it issues, and credit
balances of private financial institutions.

The multiplier effect of credit revolves around money creation as it goes on to feed an increase
in the monetary base of the central bank. The multiplier effect is in practice estimated between 1
and 3 for M1, and higher values for M2 and M3. The multiplier may change as the demand for
money persists, causing a tightening of credit (otherwise known as the credit crunch), which
justifies higher emissions by monetary authorities to maintain the quantity of money.

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:20
posted:1/23/2013
language:
pages:1